Europe’s exchanges, banks and brokers must ride a powerful wave of change. Which will seize the opportunities and which will be overwhelmed remains to be seen.

One afternoon last spring, Richard Balarkas, head of alternative trading strategies at Credit Suisse, addressed a group of fund managers at Deutsche Asset Management.

“Where do you think the best price in Deutsche Bank shares can be found?” he asked the assembled group.

When several suggested the likely venue was Deutsche Börse, Balarkas held up a print out from Credit Suisse’s own system a few hours earlier.

Contrary to conventional wisdom, both the best price from a prospective buyer and that from a prospective seller were to be found on Chi-X, a new, low-cost and high-speed competitor to European exchanges.

By contrast, Deutsche Börse offered the second-best and fourth-best prices from buyers and sellers respectively.

The fund managers, according to several present, seemed stunned. It was a hint of what is likely to occur, albeit slowly, once the Markets in Financial Instruments Directive takes effect next November.

Breaking the monopoly
Underlying the legislation is a desire among European regulators to encourage the sort of competition that lowers the cost of capital and encourages more participants to invest.

In the first instance, this is promoted through increasing the number of trading venues, of which Chi-X is only one example.

In particular, MiFID scraps one of the mainstays of its precursor, the Investment Services Directive, which allowed member states to require all trades in securities listed on their domestic exchanges to be executed through the national exchange.

In a single stroke, MiFID wipes out the natural monopoly promoted by the so-called concentration rule and enjoyed for so long in countries including Denmark, Finland, Italy, France and Spain – although, crucially, not in the UK or Germany.

Indeed, the Committee of European Securities Regulators, said: “We consider that one of the primary objectives of MiFID is to introduce competition among trading venues and thereby reduce transaction costs for the benefit of both the final investors and issuers. These results were meant to be achieved, among others, by removing the concentration rule.”

The absence of true competition in securities trading has been a thorn in the side of its largest customers for years.

Alan Yarrow, deputy chairman of Dresdner Kleinwort and chairman of the London Investment Banking Association, has referred to exchanges, after their demutualisation, as “shareholder-owned monopolies”.

Banks feel the pinch
Three investment banks, in turn, have found themselves in the headlamps of their own customers.

Faced with an increasingly competitive environment, rising distribution costs and the need to keep their charges low, fund management houses have been forcing down the commissions they are prepared to pay their brokers.

Consolidation in the fund management industry is giving customers further pricing power.

While commissions may have been as high as 30 basis points during the dotcom bubble, they are now comfortably under ten basis points.

For “black-box” electronic desktop set trading – itself a growing proportion of overall trading – commissions are generally around three to four basis points.

Moreover, the fund management community is painfully aware of - and sophisticated in its measurement of – one of the largest implicit costs it bears: market impact cost.

In simple terms, this means that an investor trying to buy a large block of stock pushes the price of that stock against him, as others, upon viewing the order, push prices up in line with demand.

That has led to brokers parcelling orders into progressively smaller orders – the average bargain on the New York Stock Exchange is now 300 shares, down from 1,400 a few years ago – and selling larger numbers of them. But because exchanges typically charge not only by the value of each bargain but by numbers of bargains, that has increased costs for banks and brokers.

And with falling commission and demands that they “unbundled” their income from trading and research, banks are finding themselves pinched.

Dark liquidity pools
So the prospect of competition is a welcome one for them. Indeed, so enthusiastic are Europe’s large banks about new trading platforms, which carry the designation of Multilateral Trading Facilities, that a group of the largest have formed their own, dubbed Project Turquoise.

The seven core shareholders, Citi7, Credit Suisse, Deutsche Bank, Goldman Sachs, Merrill Lynch, Morgan Stanley and UBS, have been joined by two new investors, BNP Paribas and Crédit Lyonnais.

These last two, which have yet to formally sign up to the platform, are particularly active in the French and German stock markets, although they have a significant presence in the UK as well.

Project Turquoise has vowed to cut tariffs by at least 50 per cent and to incorporate a facility for what is known as “dark” liquidity.

This dark liquidity is hidden from the market until after it is executed. While MiFID requires pre-trade publication of equity orders, its rules apply only for bargains of Normal Market Size.

Thus, an order of, say, 3,000 shares in Siemens may have to be reported in advance but one of 100,000 will not.

MiFID, by all accounts, will not only offer a systemic framework for dark liquidity but it will actually push some users into dark pools that had not previously used them for matching orders.

That is because MiFID, unlike its US counterpart, RegNMS, places the onus of achieving “best execution” on the banks and brokers, not on the exchanges.

Banks that might have once only directed their trades to the local exchange under the old concentration rules now need to be able to find orders in dark liquidity pools to reassure customers that they can genuinely deliver best execution.

The concept has been thrust into the limelight recently by anticipated changes to trading regimes, but it is nothing new. It has been a staple of most markets for decades. In the UK, it used to have the more benign label of "upstairs" trading.

In the US, it has been represented by the volume traded on electronic crossing networks.

Dark liquidity is made up of transactions that occur off-exchange and are therefore not visible to investors until after the transaction is complete. It does not contribute to public price discovery.

"Dark liquidity has always been there, among the broker community,” said Richard Evans, head of alternative execution at Citi. "Nothing has changed in terms of availability. What has changed is how you access it."

Responding to the challenge
The prospect of competition for the first time in an industry where, for centuries, there was almost none, is forcing the exchanges to respond in different ways.

For the London Stock Exchange, by far Europe’s largest equities exchange, the response has been threefold.

First, it has vastly increased the speed and capacity of its trading system. In June, it launched a trading platform, TradElect, which it says has end-to-end latency of ten milliseconds and, even in its initial phase, can handle the entire capacity of the current European market.

Ultimately, it represents a fivefold increase in capacity, which enables it to take full advantage of the growing role of algorithmic traders who rely on high-speed, low-cost facilities.

It has also introduced a service aimed at blunting some of the threat from another potential competitor enabled by MiFID, that of systematic internaliser.

In this mode, banks that wish to match customer orders internally with each other or those of their own order book may do so, incurring no trading charge.

Both the LSE and Euronext are launching very low-cost products enabling banks to do the matching. Both have pricing models that allow the bank to count those trades towards its monthly average volumes.

Higher volume trading on the LSE earns progressively lower tariffs, thus rewarding those who trade more and encouraging yet more liquidity into the system.

Second, it has announced tariff reductions that average around ten per cent, a move that its biggest customers have criticised as too little too late. Nevertheless, it has promised to review tariffs further in November, after MiFID becomes effective.

Third, it has warned the fund management community to be wary of fragmenting liquidity; a development it says will widen spreads and worsen prices for investors.

Banks have dismissed this as scare mongering, noting that in the US market where competition is fierce and trading has been fragmented for years, spreads are even tighter than in Europe.

“I have yet to see a single academic study showing that fragmented markets lead to wider spreads,” said the head of algorithmic trading at one of Europe’s largest banks.

But adverse publicity is taking its toll on end-users, some fund managers say.
That, however, has not lulled Europe’s exchanges into complacency.

Market data
Euronext, too, is preparing for MiFID, not only by cutting tariffs but also by greatly increasing bandwidth to improve the speed and volume of trades it can carry.

Trading services are not the only area in which exchanges face competition post-MiFID.

Data provision is a significant source of revenue for several exchanges, most notably the LSE and the Oslo borse, which is part-owned by Stockholm-based OMX Group.

According to data from Celent, a specialist consultancy, sales of market data accounted for 32 per cent of the LSE's 2006 revenue. Oslo Børs derives 27 per cent of its revenue from market data.

"The interesting thing about the data market is that it is a contestable market," said Karel Lannoo, chief executive of Brussels-based think tank the Centre for European Policy Studies, and author of a recent paper on the subject.

"It is very dispersed and it is a market you can enter very rapidly."

Europe's banks, which are the biggest customers of the data, have wasted little time trying to enter the data market.

A group of more than 14 of the largest investment banks have formed a consortium, dubbed Project Boat, to collect trade data and package it for sale. They have vowed to slash the cost of reporting trades and all its backers are committed to supplying prices to it.

Data and information service Reuters recently unveiled plans to compete in the data market by aggregating what is expected to be an increasingly fragmented market.

With shares trading on multiple platforms, keeping track of prices in real time becomes a much bigger challenge.

"MiFID is the biggest regulatory change to hit European markets in the past 20 years," said Stephen Wilson, head of exchange traded instruments at Reuters. "It's a huge challenge for the financial services industry." Among its key suppliers, he said, will be Project Boat.

New opportunities
Clara Furse, LSE chief executive, has warned that MiFID may have perverse consequences, fragmenting the price formation process, leading to worse prices for customers.

But Wilson said commercial firms such as his see that as an opportunity. One new product, known as ".X.", will show the best bid and offers for a stock across all the platforms where it is trading. "The technology will put the liquidity back together again," he said.

MiFID will for the first time create genuine competition for what has been until now a service with monopoly providers - exchanges.

All exchanges have, and will continue to have, the ability to sell real-time information about all trades executed within their own electronic order books.

The real potential is for the sale of data on trades conducted off-book or on non-domestic exchanges. MiFID will allow new trading platforms to spring up and existing exchanges to compete for each others' trading volumes.

However, there is a view that the most far-reaching changes brought about by MiFID are not the opportunities for competing with exchanges that the new rules afford.

Instead, it is the rules on best execution, which will for the first time define it as no longer simply the best price but will also include consideration of the fastest speed and lowest cost venue as well.

To fulfil the requirements of best execution, therefore, banks will need to invest significant sums in what is known as “smart order routing” technology.

Smart order routing allows an order to be sent electronically simultaneously to numerous venues and select the best price from among them.

It is this technology that was missing from the market at the time of previous attempts to foster competition with exchanges and which, for the first time, will be a force in encouraging competition even before MiFID takes effect.

Exchange investment
For exchanges, there is little doubt that the impending competition is one of the key drivers behind the round of consolidation that is sweeping the world’s exchanges.

To ensure that they offer a MiFID-defined best price, exchanges must make sure that they can attract maximum liquidity.

For that, they need constant re-investment in next-stage technology, setting a benchmark for spending that it is likely only larger exchanges will be able to meet.

Moreover, they must ensure that they are significantly faster than their competitors, allowing investors to get to the best price before a competitor snaps it up.

Finally, they must insure that their costs are competitive with those of the wider market, a factor that points to ever-lower tariffs.

Indeed, the LSE, which in August had its first day of more than one million bargains, is quietly telling analysts that the average yield per bargain is now below £1, down from £1.36 at the end of December 2006.

And MiFID has not even formally taken effect yet.

For exchanges such as Borsa Italiana, which has long relied on the concentration rule to protect its market, the attractions of hooking up with the LSE must have appeared great and by all predictions, consolidation has further to go.

The pressure of rising technology expenditure coupled with lower tariffs gives clear benefits to the largest exchange groups.

Cutting out the middle man
Meanwhile, there are suggestions that exchanges see MiFID as an opportunity as much as it is a threat.

With banks and other information technology providers threatening disintermediation – that is, cutting out the exchanges in the middle of each transaction – exchanges believe they may be well placed to do the same.

Disintermediation, after all, is a door that can swing both ways.

Eurex, the futures trading and clearing exchange that is owned by Deutsche Börse and SWX Group, the Swiss exchange, has long offered direct membership to fund managers and hedge funds.

Recently, it has greatly increased the bandwidth through which information travels to these investors, making it easier and more profitable to trade directly.

In particular, Eurex is encouraging sign-ups by algorithmic traders who use “black box” desktop technology to make trading decisions and send orders.

“We see the algorithmic trader as a huge volume contributor,” a Eurex official said in a recent interview. “We have a number of proprietary trading houses and these guys really fancy our services.”

The possibility of disintermediating the broker community appears to have some attractions for fund managers. virt-x, the Swiss exchange’s electronic trading platform for international shares, has had several approaches from buy-side firms interested in obtaining direct access in recent months.

Two years ago, when Virt-X informally canvassed members, there was no interest whatsoever.

Winners and losers
The ultimate shape of Europe’s capital markets even a year from now is anybody’s guess. But it is clear already that the group that stands to benefit most is the investor community.

Any shopper understands the benefits of competing supermarket chains, and the landscape is no different when the products at hand are financial. For listed companies, large and small, the benefits are probably less clear.

However, to the extent that it becomes cheaper and more efficient to commit capital to the market, investors are likely to do so in ever-greater quantities.

Indeed, one of the striking facets of the markets in the months leading up to MiFID is the fact that Europe’s exchanges are all reporting record trading volumes in both equities and derivatives.

Lower cost capital may not imply better run companies, but for those that are well run, the benefits are clear. Simply the threat of competition that MiFID will bring is already altering the capital markets to the betterment of consumers.

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