LSE's IOB market making plans will boost illiquid securities


The London Stock Exchange is likely to see an increase in liquidity for mid- and small-cap stocks on its International Order Book, with the planned introduction of electronic market making from next month.


The London Stock Exchange (LSE) is likely to see an increase in liquidity for mid- and small-cap instruments traded on its International Order Book (IOB), with the planned introduction of electronic market making from next month.

The LSE's IOB, which offers trading in foreign securities via depository receipts, accounts for a significant proportion of the the UK bourse’s business – around 16%, according to sources close to the IOB – with five of the 20 most heavily traded securities on the LSE traded on the IOB in the second half of 2011.

Following a public consultation which closed on 9 March, the LSE said it intended to introduce an integrated market making scheme from 2 April. Participants will be able to register to a commitment to provide a displayed, two-way quote on a security-by-security basis. There will be no obligation on issuers to have a registered market maker to remain on the IOB, but the named order functionality which is currently available to all IOB users will be removed.

At present, there is no market making on the IOB – instead, named order functionality allows any IOB trading participant to enter a single-sided bid or offer, which displays the trading participant's name against a specifically priced and sized order of its choosing. The LSE said it had been approached by a number of member firms wanting to provide market making services in one or more IOB securities. The new scheme would bring market making on the IOB in line with SETS, the LSE’s order book for UK stocks.

Market participants have expressed broad support for the LSE’s introduction of market making on the IOB, especially for illiquid stocks. However, some have questioned the effective difference that the plan will make.

“There is plenty of liquidity already on the IOB,” said Serge Alexandre, senior sales executive, global electronic trading services at Russian broker Otkritie. “Russian names account for the vast majority of volume traded there. For the top 15 names, there’s a lot of high-frequency traders arbitraging between the IOB and the local markets – so for the majority of investors, it’s liquid enough already.”

The primary benefit from the introduction of integrated market making would be for the non-Russian stocks, according to Otkritie. In addition to Russia, the IOB offers direct access to securities from 46 countries, including those in South Korea, India and Kazakhstan.

Easy availability of two-sided quotes could help boost liquidity and increase the opportunities for arbitrage trading activity. While Moscow-based broker Uralsib agreed that electronic market making on the IOB would improve liquidity and trading volumes for illiquid stocks, it highlighted the potential for some negative effects.

“In theory, the introduction of a market making system would promote liquidity, narrow bid-ask spreads, reduce volatility and improve daily turnover of listed securities,” Sarah Salamoun, head of DMA, Uralsib, told “However, in practice this same process may negatively affect price discovery, resulting in cost manipulation and a lack of competitiveness on one side of the quote in intra-day markets.”

The LSE is keen to retain its share of liquidity in Russian stocks traded on the IOB, given recent reform initiatives in the Russian capital markets. The Russian government plans to develop Moscow as an international financial centre, drawing in foreign institutional investors in a bid to drive up trading volumes and boost liquidity.

As part of that initiative, the merger between Russian stock exchanges RTS and MICEX threatens to draw institutional liquidity back to the Russian market, which is currently largely dominated by retail investors. The union of the two venues will allow market participants to clear and settle in a single market via a single central securities depository, reducing clearing costs and removing a significant portion of the complexity in investing in the Russian securities markets. The creation of a Russian central counterparty (CCP), slated for July this year, could provide a further incentive for institutions to trade in Russia.

The LSE introduced LCH.Clearnet as the CCP for trades in the most liquid IOB securities in March 2009 – a move that was intended to raise investor confidence in the safety and resilience of trading on the IOB. The LSE confirmed a deal to acquire LCH.Clearnet earlier this week. If implemented, the exchange plans to review the market making programme after its first three months of operation.