As liquidity fragmentation becomes more pronounced in Europe’s equity markets, the industry’s calls for a consolidated European-wide pre-trade data source have grown ever louder. But how would a single European best bid and offer (EBBO) impact the performance of smart order routers (SORs), which currently direct orders by using proprietary solutions that combine multiple data feeds, and will it raise more questions than it answers?
In a market where Europe’s blue-chip stocks may be traded on up to six displayed, and many more non-displayed, venues, the benefits of a European best bid and offer (EBBO) appear self-evident.
A single industry-wide EBBO that lists the highest and lowest price for major stocks across all significant European venues would finally give market participants a comprehensive view of liquidity in the region. In theory, bids and offers from all qualified trading venues would be compiled and ranked by a single EBBO, with depth of liquidity being taken into account. Market observers have also suggested that basing an SOR on a standardised price source could see more liquidity shift to alternative venues than at present as they would become a more integral part of the price formation process.
Although brokers and market data vendors have developed proprietary EBBOs, evidence suggests SORs are far from guaranteed to hit the best price every time. Trading venue Equiduct calculated that if orders were routed consistently according to best price in April, the London Stock Exchange would have lost 12.7% of its actual market share for that month, Euronext would have lost 9%, but Chi-X would have gained 11.4%.
Proprietary EBBOs are configured differently and use varying criteria to assess the credibility of venues, such as number of members connected or percentage of market share. This can skew the market in favour of certain venues and may result in a trader missing out on a better price on a venue that is overlooked by his broker’s SOR.
With a standardised EBBO solution, smart order routers would have a single reference point on which to base their routing decisions and trading venues would be on a level playing field. If all traders had the same significant venues on their smart order routers’ radar, the buy-side’s overall ability to achieve the best possible execution would theoretically increase.
“Having an EBBO will become a major catalyst and attractor to distribute liquidity towards the venues that really matter,” said Anthony Kirby, director, regulatory and risk management, financial services at accounting firm Ernst & Young. “This switch will come naturally because not only can the fund manger see the price but so can the end-client. So you will be motivated to hunt the best price to evidence best execution, and if not you will have to have a good reason.”
But a standard EBBO could leave new venues with an uphill struggle in the quest for liquidity. Whoever is charged with regulating a consolidated offering would have to determine the criteria that make venues eligible for inclusion in the EBBO.
If an upstart trading venue managed to gain meaningful liquidity in a number of select stocks, but not enough overall liquidity or volume to warrant being part of a consolidated benchmark, clients of a broker that used an SOR powered by a standardised EBBO could miss out on potential fills.
“Having an EBBO could create a two-tier system where new venues are unable to get their foot in the door because they are not part of the existing ‘clique’,” said one broker.
Most sell-side firms already claim to build their smart order routers around a proprietary EBBO benchmark and there is a sense that, for the time being at least, proprietary offerings are adequate.
“By introducing a standardised solution, you could potentially end up setting something up that is hard to regulate and maintain, and you will not necessarily be achieving anything more than people already do,” the broker added.
At present, MiFID allows both buy- and sell-side firms to determine their own best execution policies. In reality, asset managers often accept their brokers’ view on which venues are relevant and thus included in a proprietary EBBO.
If the European Commission decided to mandate a single benchmark, would this also standardise a key element of best execution, as the choice of venue included in a best execution policy would likely be determined by those included in a single EBBO?
Depending on how a mandated solution is implemented, venue connectivity may no longer be a point of differentiation between brokers, giving the buy-side perhaps one less issue to have to keep an eye on.
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