Annabel Smith: What impact does the UK’s regulatory divergence from Europe have on the buy-side?
Lynn Challenger: Prior to Brexit, the biggest impact or risk to the buy-side was uncertainty. The lack of regulatory clarity for buy-side trading made it very difficult to predict and prepare for this divergence. I did not know if we were going to have to move traders from London to cover our European clients, or if we could meet the regulatory requirements from our current locations. I could not predict the impact the potential changes would have on liquidity. All that preparation and contingency planning cost time and resources.
Coming out of Brexit, I do expect the EU and UK regulators to follow their own path to a certain degree, at least initially. This is going to place an extra burden on the buy-side to manage two sets of regulations and that cost will only increase as regulations change.
As we talk about this, it is important to note that there is also a permanence to that cost. Take the research unbundling rules as an example. It is important to note the second and third order consequences of this rule change. Along with other factors, this rule change increased the cost basis to asset managers, and it reduced the revenue streams to research firms and broker dealers. Consequently, we also witnessed a reduction in the research coverage and liquidity for small and micro-cap stocks.
I understand the Financial Conduct Authority (FCA) in the UK is considering rolling back the unbundling rules for small and micro-cap stocks, and the European Commission has already decided to do this albeit using a different market cap threshold, but the horse is already out of the barn. It is unlikely to be practical for firms to reintroduce this kind of fee back into contracts with clients. These costs are permanent.
AS: Why is the equities market becoming increasingly internalised?
LC: I think there are going to be two drivers to internalised order flow. First, it helps the buy-side trader achieve best execution. There is constant pressure to find different ways to trade at lower costs and internalisation is just one of those mechanisms where you can avoid high exchange fees and leaking information to too many market makers.
Understanding how an internalisation process works and how our orders will interact with the internaliser at a broker is easier to understand than what happens to an order when it is exposed to an exchange, including who sees it. With reduced access to dark pools, internalisation is a natural replacement.
The second is cost pressures for brokers. As the cost of operating a broker-dealer increases, brokers are incentivised to find more profitable ways to operate. There are a lot of drivers impacting costs including the constant rise in the cost of data, regulatory complexity and the residual costs of Brexit. Investing in internalisation makes sense to me because the broker can improve the outcome for their clients and positively impact their cost basis. Necessity is the mother of innovation.
AS: What are the benefits of using a systematic internaliser?
LC: Mid-point pricing is an obvious benefit. Saving half the bid-ask spread on a trade adds up over time. When you consider the amount of volume that is transacted in the market every day, you begin to realise that basis points really matter.
A second benefit is a reduction in explicit costs. Venues, including exchanges, provide a valuable service, but that service should not come with an entitlement. Fair and open competition should be the driver for market share because that is what will drive innovation.
Europe seems to be trying to discourage systematic internalisers as they did dark pools, and make sure trading volumes go through a lit exchange. However, an exchange is just another venue. Price discovery and transparency are important to our market, but forcing volume to lit exchanges is not the only answer. There are other ways to achieve the same goal, for example a centralised consolidated tape.
AS: Do you expect trading volumes taking place on systematic internalisers to continue to increase?
LC: If you keep raising costs and leaking information out to the market by making it difficult to trade on dark pools then using an internaliser is a natural consequence. The market is going to want to find a solution and if this is the only allowed solution then that is what traders will use. Water flowing down a mountain naturally over time will find the most efficient way down that mountain. If regulators keep putting up these blocks that limit the use of dark pools that in turn means orders cannot be executed efficiently without leaking information out to the market, then traders will naturally find the next best thing, which is the systematic internaliser.
If you give the buy-side numerous options on how to execute orders, whether using a dark pool, large-in-scale dark pool, systematic internaliser, a lit exchange, periodic auctions and so on, then they can optimise how and where they are going to trade. If a buy-side trader can execute at a better price for a lower explicit cost, then clients benefit. Therefore, if the performance and liquidity of systematic internalisers continues to improve, buy-side traders will naturally continue to favour these venues.
I think the desire to use systematic internalisers will continue to grow in Europe because of restrictions on dark pools, as opposed to in the UK which seems to be opening up more options for traders to optimise their trading strategies. This is not necessarily a bad or a good thing, but we could end up with a similar situation to the FX market where certain banks are able to internalise a decent percentage of the volume and the buy-side will then be able to figure out which one of those brokers is going to have the biggest liquidity pool and then route accordingly.
AS: What has been the greatest challenge the buy-side has faced post-Brexit?
LC: There actually have not been a tremendous amount of challenges for the buy-side trading desks coming out of Brexit. Like I said, a lot of time and money was spent having to prepare for the unknown, but in the end, a lot more of the costs have been absorbed by the broker-dealers and venues. They have had to split operations, realign their legal structures, launch duplicative products and move people to different countries. I am sure this is going to have a knock-on effect of consolidation and margin pressures, which eventually will make it back to the buy-side through higher commissions or reduced coverage.
Regulatory change is driving costs higher regardless if that is in the form of Brexit or MiFID III and these costs have a permanence which put pressure on margins and encourages consolidation.
Efficiency is a key factor driving our industry and with more resources going into legal and compliance, the more pressure we have to find ways to reduce costs. So, even though our traders are still in the UK and Switzerland following Brexit and we are still trading the same way using the same technology systems, we still feel the cost pressures and will continue to look for ways to improve efficiency, be it through consolidation, automation or outsourcing.