Battle of the blocks

As recently established block trading venues battle for market share ahead of MiFID II, Hayley McDowell investigates if this is exacerbating market fragmentation and which venues are coming out on top.

As a market estimated to be worth €100 billion by the end of 2018 - according to TABB Group - large in scale (LIS) trading on major European dark pools has fast become a highly competitive business. The last couple of years have seen traditional venues from firms like ITG, Instinet and Liquidnet - alongside recently established block trading venues like Cboe LIS and Turquoise Plato - battle to win market share and liquidity. The other venue that has come a bit late to the party is Euronext, having announced plans to launch its own LIS venue as other exchanges ponder entering the space. The block trading landscape looks very different from a year ago.

Despite dark caps having not yet been applied, statistics from Fidessa show the proportion of dark traded as LIS blocks has close to doubled from approximately 12% earlier this year, to almost 22.5% as of November this year.

“There is definitely a bigger emphasis on block trading venues,” says Mark Hemsley, president of Cboe Europe. “We really started in the space this year and it has been interesting to see the rise in volumes from nothing to record figures we reported recently. There have been many exchanges coming out and saying they will offer a block offering too, but the reality is they have left it too late to be a real player in the first year of MiFID II.”

Robert Barnes, CEO of Turquoise which offers its own Turquoise Plato Block Discovery platform, paints a similar picture of changes seen across the LIS landscape. "Behaviour is evolving in order to embrace the new regulatory landscape by trading blocks that are above LIS. As this ecosystem evolves, we expect the demand for electronic block trading to continue to grow,” he says.

Challenging the incumbents

So what was once a question of whether LIS activity will increase in 2018 has shifted to which venue will win the most market share, which offers the better block trading service and will all of these venues survive long-term. It’s clear they are all trying to solve a problem presented by MiFID II and the introduction of double volume caps, but interestingly the platforms all operate very differently and attempt to solve the problem in slightly different ways.

Liquidnet is considered as the incumbent by many market participants and possibly the most well-known of the block trading venues. It acts a broker providing a buy-side crossing network by embedding technology into buy-side order management systems. This is very different to Turquoise Plato where the buy-side instructs a broker to send an order onto the venue, while ITG offers a periodic auction style venue. Steve Grob, director of group strategy at Fidessa, explains the buy-side will play a key role in deciding which of the block trading venues will come out on top, but they are all very much currently in the running.

“Turquoise Plato has that buy-side support with board members consisting of mainly buy-siders,” Grob says. “Cboe LIS has the technology which is already a huge success in the US, meaning large US firms could opt for this venue because it is familiar to them. As for Liquidnet, they are considered the original block trading venue; they have been doing it for years and they are good at it. Ultimately, it will come down to the buy-side because that’s where blocks originate, so you could make the case for any of these venues.”

The Cboe LIS platform saw record growth just 10 months after its launch, with more than 100 buy-side firms on-boarded and over €10 billion executed. The development of Cboe LIS - one of the younger block trading platforms - was in some ways based on improving the more traditional venue models, some of which have encountered criticism on how they operate from competitors. In terms of which venue will win the most market share and liquidity, Hemsley explains it will very much depend on the model.

“ITG and Liquidnet opted for the single dealer approach, competing with the rest of the sell-side to put together those trades,” he says. “The other end of the scale is Turquoise Plato where they are dealer only and while that’s great for the dealers, the buy-side are looking for more control and choice in terms of execution. Our experience has been if you see buy-side meeting buy-side, they are meeting more volume as indications of interest, and that’s why I like our model, because it provides that choice. The process Turquoise Plato uses requires a firm up or potential to execute to move into another system and it’s unclear what the logic is behind that. It presents a real risk of price movement.”

On issue of potential price movement, Barnes at Turquoise Plato succinctly explains that one of the pillars of the Turquoise Plato Block Discovery is the Uncross mechanism, which was designed in collaboration with the buy-side and sell-side community, and many consider this as best in-class. There’s no doubt the Turquoise Plato block venue has resonated with the buy-side, with daily value traded figures and monthly volumes breaking records on a seemingly weekly basis throughout 2017. “The execution mechanism is designed to be uneconomic for predatory strategies, and independent analysis consistently highlights the quality of Turquoise Plato Uncross with low price reversion rates. Even as flow into the platform has increased significantly since launch, the high quality and low reversion of Turquoise Plato Uncross matching remains resilient,” Barnes adds.

From fragmentation to fishing

But what of fragmentation and will all of these new trading venues survive, say, five years from now? Market participants and experts in the block trading space differ on their opinions of this. Hemsley says there was never one single venue for it now to become fragmented. It was mainly ITG and Liquidnet dominating the space and it was already fragmented between the banks.

Calls from the buy-side for a more efficient way to trade blocks saw the establishment of new venues because trading blocks certainly wasn’t as efficient as it could have been. Although, Grob describes trading blocks as being much like trying to fish but with five rods. The orders are conditional, meaning if you put a conditional order in all five venues and you find a match the other side, before you can firm up you must pull the orders from the other venues to avoid the risk of being overfilled. Imagine trying to whip four fishing rods out of the water if you get a bite on one of the rods, before you can catch the fish… you can see the issue. He believes this is what contributes to fragmentation in the block trading.

“What makes these venues fascinating is that they are conditional and there are very interesting technological challenges in that,” Grob says. “It contributes to fragmentation and it will be interesting in 2018 to see how this unfolds. Those firms who understand how they will navigate blocks with systematic internaliser liquidity alongside existing smart order routers will be in a position of real advantage in a world where everyone is on the hooks of best execution.”

In comparison, Mark Pumfrey, CEO of EMEA for Liquidnet, looks at the growth of the conditional order type. He says dark venues continue to be great value for big institutions and this can be seen in the strong growth of dark trading over the last five years. “Studies have suggested that dark volume caps will limit the volume of dark trading, but the growth of LIS, which is not part of the denominator, will elevate wholesale-style dark trading,” Pumfrey explains. “We expect conditional order types to grow and that will make a big difference to dark trading as you can now represent yourself conditionally in different LIS venues which makes trading in size easier."

Liquidnet’s platform has gone from strength to strength with its community-based model that is actively policed to ensure no ‘funny business’ ensues and orders are protected. “Dark venues require clear and strong rules of engagement to ensure liquidity found therein is highly actionable. Policing and protocol has been a big focus for us since inception. Trading large size in the dark requires a significant amount of trust and confidence in the platform and I can’t stress enough the behavioural aspect to this. You don’t want to share large scale trading intentions unless others treat it with the respect it needs," Pumfrey adds.

In what is currently considered a rather untapped market with huge potential, it’s unsurprising the last year or so has seen a burst of new entrants offering services catering to block trading. But, as with many other markets, there will be a limit to the number of venues that will survive. Grob explains over time we will likely see even more LIS trading platforms enter the space, although as Hemsley previously mentioned, those entering in 2018 with MiFID II coming into force will likely have missed the boat. “Over time you would expect to see lots of firms throw their hats into the ring so to speak, and then four or five of them slug it out over the next few years until there are maybe two that remain,” says Grob. “If block trading follows the trend of what happened with lit fragmentation, then the number of venues will continue to grow as firms look to take advantage of the opportunity, but you can expect it to fall away again.”

He adds however, that using a block trading venue, like the ones mentioned here, is not the only method of sourcing blocks. A well informed and technology armed sales trader will be looking at other ways to stitch together these trades. This is of course part of the bigger picture however, and moving forward it looks as though the block trading platforms will become increasingly important. The bottom line is competition is what drives innovation and if demand for such capabilities continues alongside soaring volumes of block executions, then perhaps there will be enough business to sustain more than just one or two LIS trading venues.