Fireside Friday… with Cowen’s James Baugh

The TRADE sits down with head of European market structure at Cowen, James Baugh, to explore the systematic internaliser regime and which areas of the market regulators in the UK and Europe could be focusing on in the year to come.

How is the systematic internaliser landscape developing in Europe and the UK?

The electronic liquidity provider systematic internaliser (ELP SI) business is now dominated by a handful of larger players, making it increasingly important to understand when best to interact with this flow to optimise outcomes based on parent order intent and client strategy. Liquidity providers have become more adept at mitigating post-trade impact but only for a limited time period, after which information leakage may outweigh the impact of executing that business on a lit order book. Bank SIs provide further optionality and potentially more benign opportunities if you know what type of flow you’re interacting with.

In total, today SIs account for around 10% of business, significantly lower than the previous high of 15%. I don’t see a direct correlation between dark and SI business per se but clearly the introduction of the double volume caps in dark and the ban on broker crossing networks post Mifid II encouraged alternative ways of doing business including the introduction of periodic auctions and the increasing use of ELP SIs, which we continue to see as overall positive for the market.

Which market structure areas do you expect to come back into the scope of regulators on either side of the channel in the future?

As we know, in Europe focus has been on further restricting dark trading and systematic internaliser business, whilst in the UK the opposite approach has been taken. Of late there has been very little focus on frequent batched or periodic auctions. In part perhaps because they only account for a couple of percentage points of total business. But anecdotally we expect this to grow, which may encourage further regulatory scrutiny – keeping in mind the European regulator has previously flagged concerns over the nature of this business. In the UK, the new Chancellor made reference to regulatory reforms of the financial markets in last week’s mini budget, which could impact here but beyond the current sway of changes underway I’m not sure what else this could lead to but a watching brief, nonetheless.

Which proposed regulatory changes in the UK and Europe do you expect to impact the buy-side most heavily, why?

Regulatory divergence and market dislocation post-Brexit does little to support a buoyant secondary market, especially at a time when we need to support economic growth and encourage international investment. Without those inflows it makes it very challenging for the buy-side. And whilst of late we’ve heard more positive noises from Europe which could encourage more convergence with the UK rather than divergence, should we see any restrictions on dark trading below Large-in-Scale (LiS) or systematic Internaliser business as currently proposed by the EU Commission and Parliament, we fully anticipate implicit costs of executing that business to increase. And if the cost of doing business in Europe does increase, we could see trading in European shares migrating back to London. If that happens, under the European share trading obligation (STO), European investors wouldn’t be able to access that liquidity in London as the UK has still not been given trading equivalence.

Which market structure areas have been missed by regulators and how can these be addressed?

Recent regulatory oversight both in the UK and in Europe has been fairly all-encompassing, with a number of consultation papers still in play. However, the continued reliance on a primary reference price under the definition of the “most relevant market”, for alternative dark books using the reference price waiver encourages latency arbitrage and interrupts trading when the primary market is down and is therefore something that should be looked at. Obviously the introduction of a pre-trade consolidated tape could go a long way to alleviate these issues, but whilst high on the regulatory agenda I think unfortunately it seems we’re still a way off getting something over the line that we can all agree to. Separately, I think the impact of the US moving to T+1 settlement also needs to be considered by European and UK regulators, and if this is something that could be considered here. Otherwise, specifically in the UK the relaxation of rules around SI and dark business still needs to play out, the potential impact of which may lead to future and yet unknown regulatory intervention.