Primary exchanges around the world that fail to meet the needs of institutional investors face an increasing risk of disintermediation by newer, smarter platforms that do.
With exchanges everywhere focusing on reducing latency and improving their capacity in recent years – witness Singapore Exchange’s new Reach platform launched in August, the London Stock Exchange’s Millennium Exchange platform introduced in February 2011 and Brazilian exchange BM&F Bovespa’s ongoing Puma upgrade – conventional wisdom has it that speed is king.
But these improvements are merely reactive. They are not innovation. And it can be argued they fall far short of meeting the real needs of long-term investors. Like a chess player continually reacting to his opponent’s last move, exchanges are simply copying innovations introduced by rivals. This places them in grave danger of missing the bigger picture and spotting opportunities of their own.
One of the biggest potential opportunities is helping the institutional investor trade in blocks. As markets have become more fragmented in recent years, it has become increasingly harder for long-term investors to trade large blocks of stock. Instead, orders are divided between multiple brokers, further divided between different trading platforms and dark pools, and then subdivided by algorithms into child orders. The end result is that the available portion of liquidity at any one place and time is becoming extremely limited.
The ‘race for pace’ may have resulted in fast but dumb matching engines that have jettisoned flexibility in the quest for all-out microsecond latency. But as trading becomes faster, concerns over high-frequency trading in lit markets have helped fuel a flight of liquidity to dark pools. Both in North America and in Europe, trading figures show dark pools achieved their highest-ever market share in the first two months of this year. High risk of information leakage on the lit markets, together with smaller and smaller fills, recently led one senior buy-sider trader to tell The TRADE that the lit book is now “literally the last place you want to go.”
Broker crossing networks offer a tiered system, in which users are grouped according to category. Tier one might consist of electronic liquidity providers, while tier two flow might be largely provided by other brokers’ algorithms. Users can decide with which tier of flow they are willing to interact.
Buy-side preferences suggest the emergence of Facebook-style trading platforms, which can bring that kind of control to the lit markets. Market participants will be able to use social networking-style rules to expose their orders only to the specific subsets of the market with which they wish to interact. Adding order types that are not accessible to high-frequency traders, for example, could provide a ‘safe’ environment where institutional investors feel secure enough to post large blocks of liquidity.
Meanwhile, for all their past enthusiasm in principle for the lit markets, regulators are not necessarily as supportive of tailored platforms provided by exchanges as might be thought. Far from supporting their attempts to develop alternative platforms of their own, aimed at different market segments, the US Securities and Exchange Commission has – according to some press reports – launched an investigation into whether such platforms might favour larger firms at the expense of smaller ones.
While such a concern is valid, it does threaten to undermine the opportunities to follow multi-platform strategies pursued by exchanges such as TMX in Canada, which launched TMX Select in July as a platform specifically targeted at high-frequency traders, or the Australian Securities Exchange, which in summer 2010 adopted a block trading platform called VolumeMatch. But if regulators really want to stem the flow of liquidity into dark pools, perhaps they should work more closely with exchanges to develop attractive alternatives.