The argument that stock indices should include deals executed on multilateral trading facilities (MTFs) is based on the principle that as much trading as possible should be factored into index valuations. But for some sell-side functions, there may be little practical difference.
MTFs assert that, without including their volumes, some index-based investments are not based on accurate valuations of the underlying stocks. The more reticent counter that inclusion of MTF liquidity would not make any recognisable difference in index values given the marginal price differences between blue-chip stocks across trading venues.
The sell-side jury remains out. Brokers regularly refer to index values in the pricing and trading of derivatives, particularly index-based instruments such as exchange-traded funds (ETFs). But they also use the available data on index volumes and values to conduct transaction cost analysis, both on their own and their clients’ transactions.
From a pure pricing and trading perspective, one drawback of not admitting MTFs into the index club is that an index based on trading activity on a single exchange would not update in the event of an outage on that bourse, thereby bringing trading in index-dependent instruments to a standstill. Outages are infrequent but not unknown: trading was interrupted on NYSE Euronext, SIX Swiss Exchange and the London Stock Exchange in 2009.
The top four ETFs in Europe in February 2010 were the iShares DAX, the Lyxor Euro STOXX 50, the iShares Euro STOXX 50 and the iShares FTSE 100, according to asset management firm BlackRock, which operates the iShares exchange-traded fund provider. These ETFs – which are all based on indices that derive their prices from incumbent exchanges only – traded an average of US$415 million per day in February.
“The fact is that the index needs to be calculated on an ongoing basis. If they are simply stopping because one particular platform has a technical fault, that can only be regarded as a systemic market failure,” says Richard Balarkas, CEO of agency broker Instinet.
Sell-side firms also use index-specific volume and spread data to assess the liquidity characteristics of particular markets to ensure the cost-effectiveness of their prop trading, market making or sales trading activities. But fragmentation has made existing data sources unreliable. For example, a trader that wants to understand how liquidity in leading German stocks has changed year-on-year is unlikely to get an accurate analysis from DAX volume statistics, given that over 30% of DAX liquidity has steadily migrated away from the domestic exchange.
Large sell-side firms have invested in their own pan-European datasets to tackle this problem. “We build our own volume profiles for historical index analysis, which includes all trading on MTFs, to mitigate the fact that the current available data for indices only represent incumbent exchanges,” says Richard Semark, managing director, client trading and execution, UBS. “If someone without these capabilities uses an index as a proxy for market volume, their analysis of the market will be inaccurate.”
Semark says the increased pressure for consolidated pan-European market data is challenging the wait-and-see approach of indices. “The idea that you have to wait until trading on MTFs reaches a certain tipping point is unnecessarily backward-looking,” he says. “There is already enough trading on MTFs, combined with the pressure for a consolidated tape, to include them in index data now.”
Should pressure be brought to bear by the continued migration of European liquidity to MTFs, the index providers will face some difficult choices on how to reflect a wider trading universe.
“If MTFs were included in indices, there is then the question of which venues would qualify as well as whether you include over-the-counter and dark trading as well,” says Toby Bayliss, head of algorithmic and program trading, Europe, Sanford C. Bernstein. “MTFs are keen because it raises the awareness of their venues, which is a good thing for the market in general, but do the people using indices care at the moment? I would say probably not at this particular point.”
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