Liquidity spillage is key post-merger challenge for BATS, Chi-X

For the proposed merger of pan-European multilateral trading facilities BATS Europe and Chi-X Europe to offer long-term competition to incumbent exchanges, the combined entity must retain current levels of liquidity, implement stringent operational cost savings or diversify.
By None

For the proposed merger of pan-European multilateral trading facilities (MTFs) BATS Europe and Chi-X Europe to offer long-term competition to incumbent exchanges, the combined entity must retain current levels of liquidity, implement stringent operational cost savings or diversify.

BATS Europe's parent, US-based trading venue operator BATS Global Markets, confirmed that Europe's two leading MTFs by market share were in exclusive discussions about a purchase of Chi-X Europe on 22 December. The talks are expected to result in an all-share deal valued at around US$300 million. With shareholders, including some firms that currently have stakes in both BATS and Chi-X Europe, looking to reduce or ideally eliminate their exposure, the combined MTF must successfully fight off competition for liquidity from other venues. Given the paper-thin margins that all MTFs already operate on, operational cost savings may offer some help but the merged platform has relatively little room for manoeuvre if it is to be the final act of the European venue consolidation activity of the last 18 months.

By its own admission, BATS Europe has a breakeven mark of around €88 billion in monthly turnover, but its 6.2% share of pan-European trading during 2010 left the firm with an average monthly turnover of just €41 billion, according to data provider Thomson Reuters. Last August, BATS Global Market's vice president of global communications, Randy Williams, confirmed that BATS Europe needed “around €4 billion worth of turnover in Europe per day to be consistently profitable” and predicted a €3.8 million 2010 loss for the MTF based on prevailing volumes.

Chi-X Europe's breakeven is estimated at around €100 billion in monthly turnover, but the MTF averaged €130 billion per month last year and achieved a 2010 pan-European market share of 16.6%. As such, Chi-Europe reported a profit every month last year.

Head above water

A combined pan-European market share of around 22-23% could well yield the revenues to keep the combined MTF in profit, allied to reduced headcount – BATS Europe is currently estimated to employ around 35 while Chi-X Europe has closer to 50 staff – and lower costs from running a single trading platform as well as rationalisation of other common functions. But in fast-changing regulatory and competitive environment, some costs may not be easy to cut. For example, in its draft consultation on MiFID II, the European Commission has proposed that MTFs should have in place arrangements to deal with operational risk, contingency plans and strengthened surveillance procedures that would put them on a par with regulated markets. CEO Mark Hemsley has suggested BATS Europe will maintain a strong commitment to regulatory considerations. “Our secondary markets surveillance is currently comparable to best-in-class capabilities of the exchanges and MTFs and we continue to work closely with regulators in this regard,” he told

Hence, holding onto liquidity may become critical. Broadly speaking, there are three sources of liquidity leakage during a merger of trading venues. First, the volume of trading by the two merging venues will suffer some net reduction as arbitrage business conducted between the markets vanishes. Second, liquidity may also dissipate as trading systems are recalibrated to take account of the change in number of available destinations. From a technical point of view moving brokers' connections from one venue to another is simple. The task falls to the brokers, the majority of whom will have connections to both Chi-X Europe and BATS Europe. It is likely that one of the two matching engines used by the combined group would be shut down at some point in the integration process and brokers will simply close the gateway to the engine no longer being used. “But a small number of firms won't make the effort to connect to the surviving engine” said Fred Ponzo, managing partner at trading technology consultancy GreySpark, “As other firms shop around some of the flow will move onto competitors. Some flow will be lost as smart order routers are recalibrated in a way that changes the weighting of venues.” In addition, time weighted algorithmic trading strategies might be compromised by the lack of historical data for the merged venue, according to Ponzo, who notes that combined data from Chi-X Europe and BATS Europe may have to be used in the short-term until a pattern has been built up of activity on the new market. Chris McConville executive director for direct execution services at broker UBS, says that brokers' dynamic smart order routers will quickly adjust to the new market realities. “If the combined share of two merging MTFs was 20% I wouldn't automatically give that to the new MTF. I would normalise flow across all of the venues to start with and my dynamic SOR would track liquidity and calculate the right numbers,” he said. “It will be interesting to see what the liquidity will do but I'm not worried about the technical change, that's very easy.”

Third, rival trading venues are likely to try to take advantage of any disruption to attract liquidity through price promotions. Trading venues that will be keen to capitalise on any post-merger disruption include: new firms such as Quote MTF, a Hungarian-based pan-European venue and PAVE, a Spanish MTF that hopes to increase the volume of trading in Spanish equities; broker crossing networks that are being reclassified as MTFs in anticipation of MiFID II; and exchange-operated MTFs such as Turquoise, majority-owned by the London Stock Exchange Group since February 2010.

Even flow

Previous examples of trading venues merging order flow do not offer direct comparisons to the proposed Chi-X/BATS integration, nor do they offer great comfort. In July 2010, regulated market Equiduct arranged to take on the customers of MTF Nasdaq OMX Europe which had been shut by its parent, US-based exchange group Nasdaq OMX, after failing to attract a significant amount of market share. Under the agreement, customers that moved across could hook up to Equiduct via their existing Nasdaq OMX connection. Although the exact flow of customers that migrated across has not been disclosed, Equiduct's trading volume increased dramatically following the Nasdaq OMX shutdown: from trading less than €5.4 million euros in June to €31 million in July, €132 million in August and reaching €1.2 billion by December.

Although Equiduct experienced substantial growth across the second half of 2010, this could also be attributed to other factors such as its market making agreement with Knight Capital, announced December 2009, and the growth of retail broker flow. In April 2010, the month in which its closure was announced, Nasdaq OMX Europe had traded €6.19 billion or 0.73% pan-European market share.

SmartPool, a non-displayed venue run by exchange operator NYSE Euronext, attributes some of its outstanding volume growth in 2010 to the migration of clients from fellow dark pool NYFIX Euro Millennium. It had taken the venue over in November 2009, the same month it migrated to NYSE Euronext's Universal Trading Platform (UTP), which offers a single point of connectivity for brokers to all linked markets, thereby broadening Smartpool's potential user base to all NYSE Euronext members at a stroke. “The absorption of NYFIX Euro Millennium into the SmartPool trading community was one of a number of contributing factors, including our migration to NYSE Euronext's UTP that converged at the same time to create significant momentum for our business,” said Lee Hodgkinson, CEO of SmartPool and head of European sales and relationship management at NYSE Euronext. Having traded just €193 million in December 2009; by April the following year SmartPool had reached €517 million and leapt to €2.6 billion in May, a 374% increase month on month.

With even SmartPool reluctant to ascribe a major role in its growth to acquired flow, it may be that a combined Chi-X/BATS MTF will rely on diversification for the revenue growth required to take it into sustainable profit.

Rival MTF Turquoise has plans to launch equity derivatives functionality in Q2 of 2011, focusing on European index and single-stock futures and options, while Chi-X Europe launched a contracts-for-difference clearing service in partnership with central counterparty LCH.Clearnet on 10 January. BATS has so far made no announcements about its plans for diversification in Europe, but it does operate an options platform in the US and global regulatory pressure to push OTC derivatives trading onto trading venues may create a range of new opportunities for MTFs to exploit.