Balarkas, CEO of Instinet Europe, reflects on how market volumes should rise exponentially if market structures adapt to new opportunities.
Recently I have asked a variety of traders to take a guess at what percentage of global market capitalisation they believe is actually traded each day on the world’s stock exchanges. The responses have been interesting, and roughly divided between those who think it may be around 20% to 30%, and those who believe it could be as high as 300% to 400%.
An interesting range, but even the most conservative estimate appears to be way ahead of reality. If you take the stats from the World Federation of Stock Exchanges, they suggest that on an average day the amount of business traded on the order books of the world’s exchanges (i.e. completely visible) amounts to little more than 0.5% of global equity market capitalisation. Need to sanity check this? Then look at the London Stock Exchange’s most recent results statement, which highlights a main market capitalisation of £3,500 billion and aver-age daily SETS turnover of £9.1 billion, equivalent to 0.26% of market cap.
My own guess was around 20% considering the rise of high frequency traders, the shift towards active management, the turnover rate of some hedge funds and the very high levels of volatility seen in the markets. There is a surprisingly huge gap between the traders’ gut feel and reality.
This led me to another question: If the traders’ answers were read as a proxy measure for the latent demand for liquidity on a daily basis, why is the actual turnover/market cap ratio so much lower than expected?
I suggest the difference is explained by market structure. Ultimately, every buy and sell idea has to get funnelled through people and systems accustomed to and limited by existing market structures. Think about it – every idea typically ends up being implemented either by being worked on a public order book (a few hundred shares on the touch), taken as a position by a bank using its balance sheet (if you are desperate or lucky), or (if you are really lucky) crossed. We learn to live within the limitations of our environment, traders don’t even think seriously about trying to move 10 days’ volume in a single trading session, however if asked they all say, “I would if I could”.
There is huge potential for unlocking vast amounts of latent liquidity if market mechanisms can evolve, and the latent “I would if I could” business can come in many guises, not just blocks. Look at Europe as an example. New liquidity venues are emerging that offer faster, cheaper and smarter alternatives. Even the established exchanges are admit-ting that these new entrants are unlocking previously untapped sources of liquidity from ultra-fast market makers. This has proved that there is elasticity of demand in response to changes in functionality, speed and price.
At the other end of the spectrum, dark pool trading services such as Instinet Europe’s BlockMatch MTF are able to facilitate new levels of block trading. As traders and fund managers develop conviction in pricing large blocks, and the services they use pose no threat of price or information leakage, more liquidity will be unlocked. This will only happen if liquidity is not ring-fenced and if interoperability between competing venues exists. Instinet’s sole objective is to deliver execution performance to clients, not build a large pool of internal liquidity. If meeting our objective means executing entirely on external venues – be they light or dark – then so be it. New venues, including the systematic internalizes’ dark pools, must provide open access. New conflicts are emerging and brokers need to address whether their aim is to optimize the result for the client by allowing smart routing to all possible liquidity venues, or to optimize their own returns through internalization.
While much talked about, but in my opinion barely implemented in Europe, smart order routing technology is essential for brokers to fulfill their best execution requirements. Smart order routers need to be more than ‘Kelkoo’-style price comparison engines. They need to be highly sophisticated algorithms that look not just at displayed price, but also tar-get hidden liquidity opportunities and dynamically man-age residual orders across venues.
When we talk about market structure, we tend to talk about liquidity venues – exchanges, MTFs etc. Look a little deeper and the clearing infrastructure fundamentally undermines progress. The cost of clearing European equities is far too high and shouldn’t be so difficult to address. Fortis’ EMCF has managed it, and EuroCCP is set to manage it, so why can’t the incumbents man-age it? The answer is simple – the architecture and infra-structure, the mindset of the clearing institutions and the arguments for the status quo are all the same: old.
The “I would if I could” is the terra incognita of equity trading, and it is massive. Equity market structures may be changing rapidly, but in reality developments to date are only just the beginning. The good news is that with each small step in the evolution of new and innovative market structures, new liquidity gets added to the game. Turn the measly 0.5% into a paltry 1% in the next year and we will double equity market turnover – a development that should have everyone smiling.