Market participants in Europe should shift their focus from primary exchanges towards more internalised trading to reduce costs and information leakage, according to the global head of trading and order generation at UBS Asset Management.
Speaking on a virtual discussion at TradeTech on evaluating equity market structure post-Brexit, UBS Asset Management’s Lynn Challenger highlighted that the equities market is on a path of continued internalisation and Europe must adapt to this trend to maintain its resilience.
“I think Europe can build out resiliency by relying on things other than the primary exchange for the primary bid-ask spread,” he said. “Internalisation is going to lead to significant cost reduction and higher barriers to entry.
“When firms internalise they not only capture both sides of the commission, they can cross their own flow and bid and they don’t have to pay an execution fee to that venue. This cost reduction gets passed to clients to reduce commissions and from my perspective to midpoint pricing.”
Trading volumes on internalised venues such as systematic internalisers (SIs) operated by banks and brokers have surged post-MiFID II. A statistical analysis by the EU markets watchdog published in November revealed that SIs dominated the European equities landscape during 2019.
According to the analysis, the SI operated by US investment bank Goldman Sachs traded more volume annually than the London Stock Exchange’s regulated market and multilateral trading facility (MTF) combined in 2019.
“In our experience, systematic internalisers so far are cost reducing, when compared to orders facilitated on traditional markets. Internalising has a lower explicit cost base and you don’t have to pay other venues for the fee of crossing your order flow,” Challenger added.
He warned however that as internalisation becomes more popular, banks and brokers will have to warehouse risk more heavily and diversify their flow, attributing rising discussions and debate around centralised risk books related to this market trend.
“Dark pools are designed to match liquidity at the mid, but they also trade in the dark and this is a very important factor for a firm like UBS where we have found that one of the primary drivers of our transaction costs on large trades is information leakage. The more we can control the lower of information leakage the lower our trading costs will be. That is an incentive to trade in the dark.”
“The venues and markets remain connected and the smart order routers used by brokers are designed to find the best price. If the best price is on an exchange the smart order router should route to that for the trade.”
In terms of regulatory divergence between Europe and the UK following Brexit, Challenger said he believed equivalence decisions were unlikely to happen in the mid-term. Debate on the abandonment of MiFID II requirements such as research unbundling in the UK post-Brexit could also leave firms in difficult positions.
“For us the research fees that we were bundling was part of the commission dollars. You know that’s an agreement we have with our clients so we can’t go back and raise the rates, we can’t go back and put those fees back into our contracts and then as new clients come on board we can’t treat those clients differently. Rebundling is going to be a lot harder than unbundling.”
Earlier this month, the UK Chancellor set out ambitious capital reform plans to axe double volume caps (DVCs) relating to dark pool trading and the share trading obligation (STO).
The HM Treasury said on 19 April that the proposed removal of the MiFID II restrictions inherited from Europe aimed to deliver “a rulebook that is fair, outcomes-based and supports competitiveness, whilst ensuring the UK maintains the highest regulatory standards.”
The UK and Europe have been unable to reach any decisions on equivalence following Brexit. In the first week of January, the UK saw roughly €6 billion in daily trading volumes move away from the City to European capitals such as Paris and Amsterdam thanks to a stalemate relating specifically to the share trading obligation.