The trading industry is on the edge of its seat. MiFID II may be better known for conjuring up feelings of frustration and confusion, but when it comes to order flow there is a sense of anticipation as participants wait to see where it will land.
The rules will see the closure of broker crossing networks (BCNs) in the New Year, causing a seismic shift in order flow and behaviour within the trading landscape. This activity doesn’t just disappear into thin air though and order flow will have to go somewhere. Where that will be has been a topic of intense debate but as we move into 2018 we now have a clearer picture.
Despite the backlash and rumours of firms attempting to circumnavigate rules, it appears as though the European Securities and Markets Authority (ESMA) will get what they want from MiFID II in terms of transparency and activity on trading venues.
The question was once again thrown up in the air after ESMA proposed last minute changes to the systematic internaliser (SI) tick size regime in November. It said shares traded privately inside banks should be in the same price increments as on public exchanges. In other words, ESMA has levelled the playing field between SIs and exchanges and there is now all to play for in terms of which venues will sweep up the order flow and activity from BCNs in 2018.
“BCN activity is around 30% of total daily volume and market participants don’t realise how significant that is,” says Michael Horan, head of trading at Pershing. “That activity needs to find an immediate home and those who run the BCNs will suffer from losing that liquidity. The only way to keep it is to rehouse it as a multilateral trading facility (MTF), but that’s very unlikely to happen. The activity will end up with SIs or with the exchanges and that’s how it will stay for the first few months.”
The liquidity will not just disappear. People will still buy equities and markets will continue to function. Certainly ESMA has clipped the wings of SIs and reduced the head start the venues once had, so it makes sense to foresee more activity on lit trading venues, but the activity is yet to shift. Some experts have predicted a drop in volumes and order flow during the first few months of 2018 as market participants wait and see what others will do or where they will send their orders. Matthew McLoughlin, head of trading at Liontrust, says it’s understandable that many market participants expect a drop in volumes once the rules change, but reiterates the buy-side “won’t simply sit on their hands”.
SIs certainly have an opportunity to build trust - once lost in various dark pool scandals - and market share, despite the changes to the tick size regime which would have acted in their favour had it not been altered. The question remains can we expect more activity on lit venues than we previously thought? SIs were once considered to be the alternative to BCNs, but now you’ll be hard pressed to find market participants who would bet on SIs sweeping up all order flow from BCNs.
Speaking at The TRADE’s MiFID II Checklist event in London earlier this year, panellists agreed there is a place for SIs in a post-MiFID II world, but flow will not migrate solely towards that venue type and instead will migrate towards lit venues.
Ultimate determining factor
Alasdair Haynes, founder and chief executive officer of pan-European equities exchange Aquis, believes the cost of trading will be the ultimate determining factor above anything else when looking at lit venues, but the liquidity has to be there. Aquis Exchange has a unique and very innovative pricing structure in the form of a subscription model. In 2016, Haynes controversially announced plans to ban ‘predatory’ and ‘aggressive’ traders on the exchange, stressing that high-frequency trading activity is detrimental to the market. It turned out to be a good move and the exchange has seen considerable growth ever since as it evolved into one of the least toxic exchanges in Europe.
“Cost will be the determining factor above anything else, but you have to have the liquidity and the fact we have substantial liquidity which is non-toxic is even more beneficial,” Haynes says. “There’s a number of things for firms to look at, if I cant cross internally I first look at cost, then it’s about where am I able to trade and which venue is best for reducing toxicity. The beneficiaries are the lit books which of course is the intentions of the regulators. I believe Aquis Exchange’s time has come.”
McLoughlin says cost is vital to his trading desk but adds it will be even more important moving into 2018. As MiFID II brings more data through extensive reporting requirements and the use of transaction cost analysis (TCA) to prove best execution, the wheat will certainly be separated from the chaff in the exchange world in the long-term. “Reversion and impact costs will be a massive factor as to where the order flow will migrate to in a post-MiFID II world,” he says. “Trading venues with good quality liquidity, low toxic flow and high fill rates will be the winners. With more data now informing the buy-side of costs, price reversion and fill rates it will be hard to argue against using those venues.”
The overriding issue will be genuinely proving best execution under MiFID II and within that there are various characteristics, but market participants generally agree cost of transactions will be a key one. There is more onus on banks and dealers to prove they are also finding the best bid and offer spread alongside liquidity, so if a trading venue can offer these it will be hard for dealers not to route orders to that exchange. With this in mind, trading venues like Aquis Exchange should be rather successful in 2018 and it isn’t just Haynes who believes the venue will thrive under MiFID II.
Horan explains: “It is a really good model and very innovative to come up with the subscription based pricing. The decision to shut out predatory and aggressive trading activity has also worked in their favour. We analyse a lot of the data and it’s a fact that Aquis Exchange is one of the very lowest in terms of price reversion and toxicity. It is the absolute lowest in some markets.”
So why hasn’t activity on lit venues and exchanges like Aquis already grown significantly? What is prohibiting participants from opting to use such venues ahead of MiFID II? Analyst at Liberum, Justin Bates, explains the complexities of the regulation itself alongside fear and an element of waiting to see what others will do, have all played a part in this.
“I can understand how some market participants anticipated a shift towards lit venues ahead of MiFID II and we were all expecting firms to be ready for the new world and have their respective houses in order. The reality is we are dealing with large clients with complex systems, which take time to adjust. There is a fear and questioning of the first mover advantage and market participants are waiting to see what others are doing,” Bates says.
Horan adds there is a technological element to the lack of movement towards disruptive trading venues like Aquis. Algorithms have a lot of back data on other venues strategically used to determine where to send orders. As Aquis Exchange is still relatively young, algorithms simply do not have much data on the venue and so will opt for a more familiar venue.
Haynes predicts the shift will be last minute, reflecting the ‘classic nervousness’ of the industry where nobody is willing to make the first move, but somebody has to show the way. As McLoughlin already highlighted, Haynes says, “The spotlight will be on data, if the data is available to analyse then firms will look at it and liquidity should then go to venues that are providing the service to the benefit of the end client.”
Market participants have predicted the turning point will be June 2018 when we see the first RTS 27 publication under MiFID II, when all venues will be scrutinised publicly and in terms of price reversion, likelihood of execution, costs and pricing. “We will see exactly how good each venue is and when firms draw up these reports it will be very difficult to ignore a venue that has a small market share but looks great,” Horan adds. “If you’re not going to a venue that is performing well and the regulator asks why, it’s a very tricky conversation to have when that data is public. This kind of transparency, even though it’s painful for many firms, will help venues and certainly any worthy underdogs.”
There’s no doubt 2018 will be a year of adjusting for asset managers, exchange operators and broker-dealers alike, but the best execution reports as required by RTS 27 very well could be the moment the winners are separated from the losers, or even the underdogs. It’s hard to ignore the amount of market participants who have pointed to disruptors like Aquis Exchange as being ones to watch in 2018. Bates summarises the point rather succinctly: “Aquis Exchange is a venue that simply cannot be ignored in terms of pricing. When it comes to order flow. We will see migration of flow out of dark pools into lit venues, which is exactly what Aquis is.
“It should be a beneficiary of this, but there are two other major factors around that attraction other than the migration from dark pools. It presents a compelling case in terms of offering best bid and offer pricing and liquidity, and perhaps most importantly the actual cost of execution is so much lower than any other venue.”
Indeed, it will be hard to argue against that.