The only game in town

Following the removal of Swiss equivalence in the European Union in July last year, Hayley McDowell examines the fallout of the political development and finds buy-side traders are benefitting from the substantial shift in market structure.

In 2019, SIX Swiss Exchange overtook Euronext Paris to become the third-largest primary exchange in Europe. Behind only the London Stock Exchange and Germany’s Deutsche Börse, the paradigms of the European equities landscape drastically shifted during the summer months following a spat between the European Union and Switzerland. 

The disagreement in question centred on Switzerland’s equivalence status, which the EU decided not to renew on 30 June, the result of which meant that EU-listed securities could no longer be traded in Switzerland. In response, Switzerland moved to ban Swiss shares from being traded on venues within the EU the very next day. The result is that European traders can only trade Swiss equities on the SIX Swiss primary exchange via a recognised broker, or through a systematic internaliser (SI) operating in the EU, as the ban does not apply to over the counter (OTC) activity. 

The impact, traders feared, would be severe. Historically, around 30% of Swiss equities are traded on EU-based venues such as Cboe Europe, Turquoise and Aquis Exchange, and the ban implemented on 1 July saw more than 300 stocks delisted from those venues. The primary concern was that less competition and choice in Switzerland would drive the costs of trading up over time. Several weeks later, high-speed trading firm and market maker Virtu Financial published a damning report, which stated the fears of increased trading costs had indeed been realised. 

“While the impact to end investors from ending equivalence of Swiss stocks is not fully understood yet, we do observe increases in trading costs for the 100+ institutional managers included in our peer universe, with small and mid-cap Swiss stocks becoming around 20% more expensive,” Virtu Financial said. 

“With essentially only two options to source liquidity now (SIX Exchange for lit liquidity or SIX SwissAtMid for dark liquidity), anyone capturing mid-price liquidity is going to trigger a reaction on the SIX lit market from other market participants who need to cross the spread (as all other lit options have basically disappeared), thus further driving away the price on the main lit market.”

SIX Swiss Exchange, however, tells a different story.

The new landscape

Immediately after the non-equivalence decision, trading in Swiss stocks moved from the EU-based venues and multilateral trading facilities (MTFs) to the SIX primary exchange and its dark venue, SwissAtMid. SIX Swiss Exchange gathered statistics from independent data providers, including big xyt and IHS Markit, and found that SIs and OTC did see marginal increases in activity, but the primary exchange picked up the bulk of activity. 

“I don’t think I’ve ever been so popular in my life to be honest, with the amount of phone calls I received immediately after the decision,” says Tony Shaw, executive director for London at SIX Securities and Exchanges. “It was a surprise for some market participants and certain aspects, such as the dual-listed securities, did cause a few headaches for some. But overall, if you speak to the market now, they say that the market is operating efficiently.”  

Looking at the percentage of average daily turnover in Swiss equities, the statistics show that volumes in SIs increased from 22% of market share in June prior to the ban, to 25.6% the following month, while OTC activity increased over the same period from 20.8% to 23.3%. The SIX primary exchange  swept up the remaining volumes from MTFs, with a significant increase in share from 37% in June to 50.9% the following month. 

By September, the data from SIX Swiss Exchange shows a clear shift in market structure as the fallout from the non-equivalence decision becomes more apparent, with SIs, OTC and the SIX primary exchange making up 23.9%, 23.3% and 52.7% of the average daily turnover in Swiss equities respectively. 

Overall, however, trading volumes in Swiss equities were down in the months of July and August, before activity picked up again in September. The decline during July and August could be attributable to the summer period when volumes are generally lower.

SIX Swiss Exchange demonstrates through data from IHS Markit and its own database that relative spreads in blue chip and small and mid-cap stocks did widen slightly in August. Come September, however, spreads narrowed significantly. Despite the findings of Virtu Financial that spreads in Swiss equities had widened considerably in the in the wake of the non-equivalence, the data reveals that relative spread in blue chips narrowed from 4.0 bps in June, to 3.6 bps in September. Similarly, relative spread for small and mid-cap Swiss stocks narrowed from 20.4 bps in June to 18.9 bps in September. According to Shaw, spreads could tighten even further as traders and algorithms adapt to the new Swiss trading landscape. 

“It takes a while for the liquidity providers to recalibrate their algorithms from fragmentation to just the one venue,” Shaw explains. “You can see this in the data, they almost back away from the market immediately after the decision until they have sufficient data to come back in. I expect that over time the spreads will tighten even more as the liquidity providers get more comfortable with the risk profile of the market. The more comfortable on risk they are, the tighter they will start quoting, and we are seeing that with one or two of our members already.” 

At the same time, the order-to-trade ratio declined significantly following non-equivalence in July from seven – meaning that for every seven orders, one is executed – to four in September. Shaw says that this shows greater certainty of execution on the order book because the liquidity is concentrated on a single venue, so traders are more likely to get a fill. Subsequently, the number of updates in the order book dropped considerably, with the average daily number of price updates in blue chips declining from just under 8,000 in the second quarter 2019, to just over 5,000 in the third quarter. 

Positive development 

This picture painted by SIX Swiss Exchange since non-equivalence, with tighter spreads, greater certainty of execution, and a less ‘noisy’ order book, coincides with that of buy-side traders, many of whom agree that the political development and removal of fragmentation introduced under MiFID I has, in fact, turned out to be very positive for the buy-side, despite the initial sense of cautiousness.   

“What has happened with Swiss equivalence has been great for us. We are seeing more liquidity, which is evenly distributed throughout the day, less volatility and tighter spreads,” says one London-based asset management trading head who spoke to The TRADE on the condition of anonymity. “We are back in a situation pre-MiFID I where there was only one exchange. Nobody really wanted the fragmentation that came with regulation, and with Swiss liquidity there’s no reversion because all of the liquidity is one place.”

For domestic asset managers, the outcome of non-equivalence has been similarly positive. Eric Champenois, head of the trading desk at Swiss asset manager Unigestion, says that not only has the concentration of liquidity on a single venue led to great operational efficiency, it has also seen the costs of trading decline. 

Champenois states that in certain small and mid-cap Swiss securities, his trading desk saw a hugely significant 25% reduction in spread in the third quarter of 2019 from around 4.5 bps in the previous quarter to 3.3 bps. Similarly, spreads in the blue chips, he adds, have narrowed quite heavily by more than 10 bps in some cases.

“Generally speaking, we saw a real improvement in terms of liquidity, and trading on one exchange is making things a lot easier for us. It’s more transparent and our execution costs have been declining as well,” Champenois explains. “Immediately of course, we saw trading volumes move to the Swiss Exchange. Before the non-equivalence decision, we saw around 73% of flow traded on the primary versus 27% traded on the MTFs. Now, 100% of that flow is traded purely on the Swiss Exchange and it’s been a very positive development for our trading desk.

“For Swiss equities we do a lot of electronic trading compared to other regions. We use a mix of DMA (Direct Market Access) and algorithms, and I would say there hasn’t been a substantial change in our strategy or methodology. However, venues like SwissAtMid have been a good addition to our workflow in the dark space. If you look at our statistics in terms of execution venues, we see clearly the benefits of more midpoint crossing opportunities with SwissAtMid. Most of the brokers we know have been connecting to SwissAtMid over the past few months, and the algorithm we use is seeing massive flow to the venue.” 

Resting block liquidity 

SwissAtMid, SIX Swiss Exchange’s dark venue, has arguably been the biggest winner of the removal of Swiss equivalence. Prior to the decision, SwissAtMid held around 40% of the Swiss dark market, competing with the likes of Turquoise, UBS MTF, Cboe LIS, Goldman Sachs SIGMA X MTF, ITG Posit and Instinet BlockMatch MTF. By September, SwissAtMid absorbed all the dark flow in Swiss equities that was previously traded across other dark pools. At the same time, the market saw more dark trading in the third quarter of 2019 following non-equivalence compared to the prior quarter. 

“It’s important here that there is actually more dark trading happening now than before, meaning that the pie isn’t getting smaller,” SIX’s Shaw says. “Furthermore, we see that a significant 86% of resting liquidity in SwissAtMid is large-in-scale, providing market participants with greater ability to get that block by interacting with larger scale volume that’s coming in.”

Switzerland is not subject to MiFID II’s double volume caps, which restrict dark trading across Europe, and there is significant block liquidity resting in the SwissAtMid dark pool. If there’s one thing traders are seeking, it is block liquidity and the ability to cross without moving the market. Due to the lack of restrictions on dark trading, rather than establishing periodic auctions or large-in-scale liquidity pools as many exchanges across Europe have done to help market participants manage the requirements, SwissAtMid now encompasses all of the dark volumes, including block liquidity. 

There are several key features on the dark venue which could help SIX Swiss Exchange retain the increase in activity should the political climate shift and equivalence be reinstated. SwissAtMid has introduced new order types, including the limit plus and iceberg plus orders for dual representation in both the lit and dark order books, to help traders navigate and interact with SIX as a single venue. SwissAtMid also offers ‘sweep’ functionality, which essentially means traders can choose whether to post an order in the dark and rest there until the other side is found, or they can sweep from the dark book straight through to the lit book to find the other side. For those looking to ‘aggress’ the order book rather than resting liquidity on the central limit order book, there is a chance to match midpoint on the way through, so there is potential to save half the spread. 

The sweep functionality may not be unique to SwissAtMid, but the fact that it sits on the same matching engine as the lit order book is. It means the venue looks at orders in the same cycle, removing the potential risk of getting ‘gamed’ on the way through as nobody can get ahead of your order. This feature is also particularly attractive to those posting liquidity because it means fills are more likely; the more comfortable liquidity providers are with the venue, the tighter they will quote. 

Hanging on

“Equivalence with the EU is desired by SIX as we believe that in the long-term it is beneficial to the Swiss financial centre, offers a fair and level-playing field for competition and is wished for by investors and clients/market participants,” reads SIX Group’s official position on equivalence. 

There are several scenarios whereby the market could see the end of non-equivalence. The UK’s departure from the European Union means it will become a third country to Europe, so technically the UK and Switzerland could recognise each other, in which case the UK-based MTFs would likely pick up that volume up again. Switzerland could also sign the trade agreement which started the disagreement in the first place, or the EU could move to renew the equivalence. 

“The Swiss exchange needs to do something to hang on to that liquidity,” the London-based buy-side trading head adds. “Our algorithms and smart order routers are now pre-programmed to go to one exchange, and if we see more exchanges in the future in light of further developments, there is no reason that liquidity should go back to the other exchanges. It has been interesting to see this play out in the market. We measure the transaction cost analysis on SwissAtMid, and we are getting great execution.”

Much like Brexit, it’s unclear how this will play out, but it is clear that there is an opportunity for SwissAtMid and SIX Swiss Exchange to retain the surge of activity and volumes that it has seen in the third quarter this year. As SIX Swiss Exchange is now the only game in town, so to speak, it has seen an uptick in the use of its services whereby traders who may have only interacted with the central limit order book are now also using the dark venue. 

It is, in some sense, becoming increasingly unlikely that in the event of renewed equivalence the market would see an ‘elastic band’ effect, with volumes returning to the MTFs and European venues. With the new functionality, recalibrated algorithms and smart order routers, SIX Swiss Exchange might just retain its spot as the third-largest exchange operating in Europe. Although, as Shaw concludes, the group is not leaving this to chance. 

“We are not resting on our laurels,” he says. “We know that this isn’t a long-term development so we are looking to get more into the order book and improve. There is various new functionality that we want to roll out next year to further increase the attractiveness of our venue.”