Stock Exchanges feature: Survival of the fittest

The rash of new execution venues in Europe is leading to increased competition, lower prices and enhanced technology platforms, intended to give a speed, capacity or continuity edge. Is there room for all these exchanges though, especially in the present depressed markets? Neil Ainger looks at the fight for survival

Competition in the stock exchanges space is growing, with new entrants such as Börse Berlin’s Equiduct Trading entering the market and other trading venues, such as Chi-X, taking advantage of the EU’s Markets in Financial Instruments Directive (MiFID) to offer alternative pan-European trade execution services. All the national stock exchanges in Europe are now competing against each other in the rapidly changing environment brought about by MiFID – even leading global wholesale banks, such as UBS and Deutsche Bank, joined together under the Turquoise banner last year to assist the launch of their own multilateral trading facility (MTF), a term invented by MiFID for alternative platforms, although now that its initial liquidity agreements with market makers have lapsed Turquoise may struggle for volume or even survival. No more so than rivals such as Bats Europe or other new entrants though, in a suddenly very crowded space where there are perhaps more venues than present volumes justify?

The old incumbent exchanges have not been slow to respond to the challenge from these newcomers either, with the London Stock Exchange (LSE) investing in its improved TradElect technology platform, and the merged entities of NYSE Euronext, with its Universal Trading Platform (UTP), and Nasdaq OMX also investing in new technologies. Deutsche Börse, which may yet be swallowed up by NYSE Euronext, is also due to launch its Xetra International Market, using its Xetra electronic engine, towards the end of the year for trading in European equity and index derivatives across 19 countries. The entire marketplace is therefore currently undergoing a considerable shake-up, with new entrants and savage competition driving down prices, and new trading techniques, such as algorithmic machine-based systems, forcing investment in new technologies that offer more capacity, speed and quality of execution, including the ability to prove it, as required by MiFID.

“Put simply, MiFID has brought new trading platforms to the European market and increased the level of competition,” agrees Yann L’Huillier, CIO at Turquoise. “This has indisputably lowered the cost of trading, but the entire market has also benefitted from improvements to trading infrastructure and service innovation. When they were in a monopoly position the incumbent exchanges had wide-ranging pricing power and failed to develop their service offering, as they had little incentive to do so. But competition breeds the will and the need to differentiate.”

Pricing
According to the latest research note from the TowerGroup consultancy, produced in February, the cheapest of the new entrants to the European securities execution market is Chi-X, which was the first to launch even before MiFID came into effect on 1 November 2007. It beat the established incumbent exchanges in both high and low volume scenarios run by Bob McDowall, the European research director at TowerGroup, with the LSE coming second on price, and Deutsche Börse and NYSE Euronext lagging behind. The best price in the low volume test was EUR 5,000 versus a high of EUR 61,916, with clearing costs – handled by the European Multilateral Clearing Facility (EMCF) in Chi-X’s case – causing a significant difference as well. The post-trade clearing arena is something that has yet to be as dramatically affected by MiFID as the exchanges, but this change is coming on the back of the EU Code of Conduct, Giovanni and various other drivers.

One thing that should be kept in mind in the TowerGroup research note is that it covers explicit costs, and the practice of incumbents to offer ‘bundling’ reductions to high volume single users can complicate comparisons. Also, of the new entrants, Chi-X leads in some categories, versus other new execution venues, but not necessarily in all, and other new venues are still coming on steam. Still, the CEO of Chi-X, Mark Howarth, is entirely justified in saying: “We’re an order of magnitude cheaper than incumbent exchanges and do not have any tiering, bundling or other such mechanisms in our prices, so we’re simpler as well.” The Chi-X venue won the FST Award this year for Best Trading Platform.

Technology
Price isn’t everything however, you still need to offer resilience and continuity of operation, something the older established venues with their higher staffs and budgets are perhaps theoretically better able to do. In addition, the technical specification of your platform, in terms of the speed and capacity it offers, is also important. “Yes, pricing is obviously going down but it’s a war with lots of battles, including capacity, continuity and so forth,” warns TowerGroup’s McDowall. All of these things need to be taken into account when deciding which exchange to use in order to execute your order. Value-add services, such as the ability to prove best execution, and latency is increasingly being used as a selling point by incumbent exchanges as MTFs eat away at their margins and market share.

Chi-X can process 225,000 messages per second and claims to have a low latency, which is better than the LSE, of just 400 microseconds, although this is only available where clients use their proximity hosting service. Turquoise has an integrated order book where displayed and non-displayed ‘dark’ orders interact and uses a modified version of Cinnober’s TradeExpress engine, which can process 120,000 transactions per second. The incumbent exchanges’ investment in systems, such as the LSE’s TradElect or NYSE Euronext’s UTP, mean that they intend to compete technologically with the new entrants by replacing, or at least, updating their legacy systems to try and fight back against these nimble newcomers. Indeed, it is likely that the traditional players will transform themselves into some form of lower-cost providers organically, or through acquisitions of MTFs, aping the arc of the American marketplace after the rise of independent electronic communication networks (ECNs) and their subsequent adsorption by many of the established players, believes TowerGroup’s McDowall. “MTFs will continue to erode the market share of traditional exchanges in Europe, albeit gradually, as their substantially lower transaction costs and increasing concentration of liquidity become more apparent to market participants,” he adds. That being the case, more acquisitions would seem to be inevitable.

Usage figures
The trading volumes going through the new entrants to the marketplace and the incumbent exchanges necessarily fluctuate, especially with the spike in volumes caused by the financial meltdown last autumn and the subsequent general decline post-crunch, but it is clear that the MTFs have eaten into the permanent flows of the established players. According to the Federation of European Securities Exchanges (FESE) latest March 2009 statistics on European electronic order book equity trading, Chi-X was the leading MTF with over 10.5 million trades, followed by Turquoise on almost 3.4 million. This compares with 17.3 million for the established LSE in March and 15.3 million at Euronext, even beating Deutsche Börse, on 8.1 million, into third place. The value of these trades is still however less, with Deutsche Börse’s worth EUR 95,835.8 million versus EUR 57,168.5 million on Chi-X.

The newcomer is only offering trade cash equities at the moment, so doesn’t provide so many options yet. “We’ve experienced steady growth though,” asserts Hirander Misra, COO at Chi-X, “and on a number of days we’ve been the third most popular venue in Europe [as shown by the figures above]. Just this week, as we talk [end of April], we’ve had 25 per cent of the market, for example, in the FTSE. In Germany, we typically get ten to 15 per cent; ten per cent in Belgium; and we’re doing well in the Netherlands and other places too.”

The shakeup has certainly given market participants many more options, which they seem to be using, and fragmented the marketplace, driving down prices and focusing attention on the technical capabilities of exchanges. “MiFID and the changed trading environment hasn’t done a lot for the listed companies themselves though,” comments TowerGroup’s McDowall. Profits and share prices at the exchanges, especially the incumbent venues whose shares were driven up by earlier merger fever, are falling dramatically. The present recession, and promised overhaul of the financial system after the recent G20 meeting in London, with more restrictions and potentially costs, doesn’t bode well for a quick recovery either. The FTSE Mondo Visione Exchanges Index, which tracks the share prices of dozens and dozens of global venues, is still showing a 3.5 per cent decline year-to-date, for example, despite the recent spring rally in volumes after the nadir in Q1.

Conclusions
The proliferation of trading venues in Europe is leading to greater fragmentation but there will eventually be a reaggregation of liquidity. The TowerGroup consultancy expects no more than eight to ten platforms, and more likely as few as five or six alternative venues, to exist within the next five years. As Turquoise’s L’Huillier says “you want enough fragmentation to ensure competition but not so much that it’s destructive and almost for the sake of it”.

The new entrants have to be careful not to try and do too much and to compete with established players or newer competitors in all spheres, dragging them away from their niche offering. Chi-X Europe, for instance, is launching its Chi-Delta dark liquidity book in Q2 2009, subject to regulatory approvals, but this will have to go up against the LSE’s Baikal dark pool of liquidity (i.e. non-displayed trades), which is being gradually introduced this year. The contract to build the order management and smart routing technology was recently awarded to Fidessa and the problems following the collapse of Lehman Brothers, the original investment banking partner, have been overcome with a ‘build-it-and-they-will-come’ mentality being adopted. At the back-end, Baikal settlement will be provided by BNP Paribas Securities and clearing via CC&G, the clearing house inherited from the LSE’s merger with Borsa Italiana. The Nyfix Euro Millennium dark pool, recently altered under instruction from the FSA to better comply with the Committee of European Securities Regulators’ demand for more transparency in pre-trade pricing, is also in this ‘dark’ space, as are various other players, so Chi-X will not necessarily find it easy to leverage its established equity execution position into new specialisations. Older incumbent exchanges with years of relationships built up with clients may be at a competitive advantage here, but only time will tell.

Equiduct Trading is also branching out by offering a suite of analytical tools that it says can help market participants find best execution and the best price. The Orange Liquidity Fragmentation Analytics (LFA) is a post-trade tool that can locate the best price for the 500 most traded stocks in Europe across the seven major venues. Equiduct says its January results show that 25.7 per cent of trades executed on the LSE could’ve been conducted better elsewhere, with 61 per cent ideally being directed towards Chi-X; 28 per cent to Turquoise; and nine per cent to Bats. The LFA and other such tools, combined with smart order routing systems, will become increasingly important in the shattered stock exchange landscape post-MiFID, where savage competition rules.

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