Brokers must embrace the concept of liquidity fragmentation more wholeheartedly if the UK equity market is to avoid a repeat of the stasis that followed a technical failure at the London Stock Exchange (LSE) seven days ago.
After a connectivity glitch at the LSE brought trading in London to an almost complete halt on 8 September, some buy-side firms have doubted the ability of brokers to switch orders between execution venues effectively, despite the fact that Chi-X, a multilateral trading facility that has been operational for 18 months, now consistently accounts for 20%+ of UK equity trading volumes. “This should have been a great opportunity for Turquoise, Chi-X and everyone else to gain market share dramatically against the LSE. Part of the problem is that there are only three to five brokers across the whole market that have genuine smart order routing technology in Europe,” said Adrian Fitzpatrick head of investment dealing, Aegon Asset Management UK. “If you had true smart order routing, it would bypass the primary exchange and go to the next source of liquidity.”
While equity brokers and asset managers have paid lip service to the idea of sourcing liquidity from multiple trading venues, many of the necessary changes to buy-side and sell-side internal workflows have not taken place. This suggests that, despite an increasing level of comfort with trading on Chi-X in recent months, the MTF has not become an integrated part of the trading process for most market participants. “Chi-X has only started making sense to people in the last few months,” said one broker. “Many didn’t have Chi-X market data on their screen, only the LSE’s data, so they didn’t know what price to trade at. These are the elementary things that clients told us about the issues that prevented them trading. It’s not that they didn’t want to, they just didn’t have the tools.”
Guy Sears, head of wholesale at the Investment Management Association, agreed that the buy-side’s reliance on LSE data was a source of concern. “The reason why the outage mattered for the buy-side was not only for transactions and not having the order book available, but also because funds and portfolios are priced off the exchange,” he said.
A large number of brokers have connected to Chi-X and Turquoise, which started trading in August, to route client orders to multiple venues as part of their commitment to MiFID’s best execution principles. But a number of their technology platforms – order management systems, corporate actions systems and other trade processing systems – still use a single price reference data source, i.e. the London Stock Exchange. “Many brokers were too dependent on a single point of information,” said Peter Randall, CEO, Chi-X. Once the LSE stopped trading, many brokers could switch their order flow to Chi-X, but few could switch their internal systems to a new source of price information. As such, trading slowed to a standstill.
Joe Ratterman, CEO of BATS, which is launching its own pan-European platform in November, said the decision by brokers to halt trading was a reflection of “the minimal levels of cross-linkages between firms and alternative market centres” at present. “It will take time for the European trading community to make their connections to alternative platforms and to trust price discovery that comes from competing market centres, but eventually it will work.
Eventually traders won’t live in fear that a single market’s system failure can cause trading to halt for the whole country,” said Ratterman.
The handful of brokers that have already adopted a more distributive approach to price formation were able to take Chi-X’s prices, but collectively they were unable to provide sufficient liquidity to support a universal switch. Randall admits Chi-X’s prices were slightly wider than the LSE’s in some stocks. “Because not everyone switched over, the depth of liquidity wasn’t always there,” he said.
Citi was one of the brokers that switched order flow away from the LSE, but subsequently found that the majority of the market did not – or could not – move with them. “We moved over to Chi-X and Turquoise instantly, but there was a drop off in liquidity because the majority of market participants use the primary for price discovery,” said Tom Middleton, head of algorithmic products, EMEA, Citi. “It was hard for people to post limit orders with confidence to give liquid order books on those venues. So we did what we could but it was limited.”
Nevertheless, Chi-X’s Randall insisted that the platform is proving its worth to users. On Friday, Chi-X reported average price improvement of 3.35 basis points on UK stocks, based on a 21.44% market share of all trading in stocks listed in the FTSE 100 index. The platform also posted record turnover of €6bn+ last Tuesday, despite the LSE’s return to normal operations.
Randall claimed that continued dependence on the LSE for market data was resulting in a “misleading” view of the UK equities market. On Friday, the daily value of trading in ten highest-volume stocks on Chi-X (including RBS, HSBC, Barclays and BP) stood at €1.089 billion. “One of the lessons of last Monday is that there needs to be an industry-wide examination of the dependencies on a single supplier,” said Randall.
Such an examination might be hastened by the apparent lack of information provided by the London Stock Exchange, either on the nature of the technical problem that prompted the outage or the steps taken to remedy it.
A number of brokers have expressed surprise at the lack of information from the LSE. One senior source at a global broker-dealer said that, as of Friday afternoon, the firm had little more information than that available to the public via the LSE’s website. “We have asked for more information on how they dealt with the problem on the day,” said the source. “Everyone has technological outages but the main aspect is how did they deal with it. I would have expected an exchange of that size to give us more information. They should have been transparent about what actually happened.” Citi’s Middleton confirmed the lack of information. “We were told a change was made to prevent it reoccurring, but we don’t know what that is,” he said. On Friday, the LSE has declined requests to confirm whether further information would be made available to clients.
Middleton suggested that the events of last Monday would prompt market participants to review their price formation processes with a view to taking fuller account of increasing levels of fragmentation in UK and European blue-chip liquidity. “This has encouraged people to move across to consolidated volume feeds and order books, so they can look at all venues in all their applications, so that price formation occurs on a number of venues,” he said, “I think it will rapidly increase the take up of these kind of products.”
Both buy-side and sell-side observers agreed that the outage was likely to accelerate the shift toward a more truly fragmented equity market, with firms making the necessary changes in the coming months to be able to trade on the other markets in the event of a similar long-term glitch. “People were expecting a magic switch to be turned on, and flow to be moved to the MTFs as soon as the other market went down. But it’s not that easy to move tens of billions of dollars of flow instantaneously. It takes time and I think this move is happening, and happening pretty quickly,” a sell-side source said.