Alternative trading revolution grips Europe
Chris Smith, head of business development for Euro Millennium and director of NYFIX International, explains why technology and trading innovations are leading Europe to new frontiers in equity trading.
There is little doubt we are witnessing a trading revolution in Europe that is linked to the emergence of new and innovative trading venues and the creation of new sources of liquidity. As the European markets’ infra-structures undergo rapid change, the ability to access both dark and light liquidity is creating new challenges and opportunities.
A number of catalysts are supporting this revolution. The first is the rise of electronic trading. Growth in demand for FIX, FIX services and expertise is tremendous, as is the use of algorithms. Research indicates that as much as 10-15% of a typical European buy-side firm’s trade flow uses algorithms, with much larger percentages coming from hedge funds.
The second is the impact of common regulations. The introduction of MiFID, with its removal of concentration rules, conditions for transparency and best execution requirements, has boosted competition and pushed traders to develop new strategies and techniques.
The third key factor driving the revolution is the growth of information. There has been a steep rise in the availability of market data, which has to be properly managed and evaluated. It is essential for today’s traders to make use of analytical tools and transaction cost analysis (TCA) to make more informed trading decisions and identify the best sources of liquidity.
These catalysts, combined with the provision of new trading destinations offering light and dark liquidity, are creating an inflection point in the history of trading in Europe.
The US evolution
While the outcome of this ‘alternative trading revolution’ remains unclear in a European context, the experience of US markets provides a useful comparison. In the US, change has been more evolutionary than revolutionary. The market has evolved during the past decade through a combination of new technology, regulation and practical necessity. This led to market fragmentation with the development of alternative trading facilities, an explosion of off-exchange trading and the emergence of dark pools.
In the US, firms have adopted more sophisticated trading techniques to take advantage of new trading destinations. To keep up with the increase in market data volumes and client reporting requirements, firms have moved away from simple order-taking functions and have acquired sophisticated execution skills on the trading desk. Order workflow has gone from a relatively simple process to an intricate number of execution options that access a range of algorithms and trading venues.
In Europe, the markets are showing the first signs of fragmentation as a plethora of new venues, each offering slightly different value propositions, are developed and launched. One thing is certain though, order workflow has become more complex as firms deploy and adapt to new ways of sourcing liquidity. Many buy-side firms are upgrading their technology to handle increasingly sophisticated trading and to benefit from dark liquidity. Dark pools can bring significant benefits, such as reduced market impact, lower information leakage and larger fills, than the traditional public or light alternatives. They also have huge potential as aggregation tools and can bring massive savings through price improvement.
Competition hits exchanges
In this competitive environment the exchanges face diverse challenges. In the US, the success of dark pools has seen volume move off the main two exchanges. The percentage of market share in equity trading of NYSE and Nasdaq has declined over the past eight years. By the end of 2007, equity trading on these exchanges accounted for around 76% of the market. According to recent estimates by the Tabb Group, this figure is expected to decline to about 67% over the next two years. Dark books account for approximately 8%, while ECNs take 14% of the total flow. Dark pools are expected to grow, and by 2011 it is expected they will account for between 15% and 20% of total US equity turnover.
The interaction of a growing number of European providers will encourage the exchanges to innovate to stay competitive. We are likely to see lower prices and greater speed. For many years, Europe’s exchanges have extolled the virtues of the public limit order book. While this mechanism achieves price formation in large liquid stocks, it is not necessarily ideal for mid-cap and small-cap names. Institutional block flow may also be better placed else-where. In markets where spreads are wide, clients will look for significant price improvement by trading away from the public exchange.
New offerings
A new breed of dark pools offering greater flexibility is emerging. NYFIX’s Euro Millennium™ – the first truly open dark pool, launched in March – is building liquidity by offering buy- and sell-side firms access to a neutral, flexible execution tool.
NYFIX expects to play an important role in the dramatically changing European trading landscape. Our recent acquisition of FIXCITY, a specialist in liquidity discovery solutions, is just one example of how we are working to meet client needs. With the development of dark IOIs as a tool to help traders find new sources of dark liquidity, this recent acquisition will serve to strengthen our ability to aggregate liquidity for clients.
Clearing the way
A potential inhibitor to this trading revolution is the lack of standardisation in the pan-European clearing and settlement infrastructure. The next few years will see significant developments in this area, however, with initiatives such as TARGET2-Securities, the European Code of Conduct on Clearing and Settlement and the recent Link Up Markets venture, all seeking to transform existing processes.
Given the numerous intricacies between member countries, Europe is unlikely to follow the US. Yet, what is certain is that advanced trading technology will enable firms to be more efficient, seize new opportunities, and employ more sophisticated trading strategies. NYFIX’s ultimate goal is to support the European marketplace so that the full potential of new technology and ways of trading is fully exploited.
