Changing exchanges

Several multilateral trading venues have set up shop, freed from regulatory restrictions with the advent of Mifid last year. But exchanges are also stepping up to the challenge, launching a variety of new services to attract algorithmic traders and statistical arbitrage funds. By Ryan Davidson

Stock exchanges in Europe have traditionally held a privileged position. Rather than compete for business, European bourses were aided by rules that specified equities could only trade through regulated, domestic exchanges - restrictions critics claimed led to unreasonably high prices for trading stocks. Those rules have now been swept away. The European Union's Markets in Financial Instruments Directive (Mifid), which came into effect last November, opened the way for greater competition in the trading of stocks - and in its wake, various alternative trading venues have sprung up.

But the continent's exchanges are not taking the challenge lying down. Keen to attract the array of statistical arbitrage funds and algorithmic traders targeted by the new venues, bourses are launching new offerings of their own. At the same time, both exchanges and liquidity platforms are looking to extend the concept, with some pondering a move into derivatives.

Traders say the emergence of more platforms is positive, and will lead to lower trading costs. "The extra competition from all the new alternative trading venues being launched is good for the market. It will provide more liquidity and price opportunities, and as a result better execution quality," says Richard Balarkas, London-based chief executive of brokerage firm Instinet Europe.

The exchanges shake-up can be clearly traced back to the introduction of Mifid last November, a regulation aimed at creating a more transparent single market for financial services in Europe. One of the key modifications was to abolish the so-called concentration rule, in place in certain European markets, which required orders to be routed through to their domestic exchange.

Under Mifid, banks have to achieve best execution on behalf of their clients, taking into account price, costs, speed, size and likelihood of execution and settlement. The bank needs to decide what factors should be given priority for each customer, and consider account exchange fees, taxation, commission and clearing and settlement fees. Importantly, the bank has to identify all available execution venues - not just exchanges.

New venues

This set the scene for the emergence of several alternative trading venues. Four have already been launched, with more set to follow in the coming months. One of the most recent platforms is Turquoise, a pan-European open equity trading platform facility, launched with a limited set of 10 instruments on August 15. Its full launch was scheduled shortly after Risk was due to go to press, on September 4.

The London-based platform is backed by nine major investment banks - BNP Paribas, Credit Suisse, Deutsche Bank, Goldman Sachs, Merrill Lynch, Morgan Stanley, Societe Generale and UBS - and is designed to compete with exchanges as well as other alternative trading venues. Turquoise integrates a dark pool - where equities are traded without revealing to the market who is trading them or the size of the orders - and a visible order book. This essentially combines displayed and concealed bid/offer prices, enabling traders to hide trade information if they wish to minimise the effect on prices.

Turquoise joins New York-based financial technology firm Nyfix, which launched its dark pool, Euro Millennium, in March this year. And even before Mifid came into effect, small and mid-cap equity platform Plus Markets (owned by London-based Plus Markets Group) obtained approval from the UK Financial Services Authority to launch an investment exchange in July last year. Meanwhile, Chi-X, a pan-European equity multilateral trading facility developed by New York-based broker Instinet, was launched in March 2007.

More platforms are set to follow in the next 12 months. Borse Berlin plans to unveil its Equiduct platform by the end of this year, while New York-based stock exchange operator Nasdaq-OMX and Kansas-based alternative trading venue Bats both plan to launch European trading facilities.

Already, these nascent alternative venues have snatched market share away from the established European exchanges. In June, Chi-X had a 3.56% market share by trading volume, while Plus Markets had 0.92%, according to Thomson Reuters. That compares with the London Stock Exchange Group with 45.52%, Euronext with 6.16% and Deutsche Borse with 3.82%.

"The introduction of Mifid, with its removal of concentration rules, has enabled the formation of multilateral trading facilities that can compete with the traditional exchanges. As a consequence, the exchanges recognise the trading landscape is changing rapidly and they have to innovate to stay competitive," says Richard Hughes, London-based managing director, client operations, Europe, the Middle East, Africa and Asia-Pacific, at Nyfix.

One of the big attractions of the new trading facilities has been price. For instance, Chi-X claims it is up to 10 times faster and 10 times cheaper than traditional exchanges. The trading fees for execution on Chi-X are 0.3 basis points for aggressive execution (incoming orders that hit existing orders on the platform, resulting in an execution) and 0.2bp for passive execution (orders that execute as a result of being hit by an incoming order). There is a flat £210 a month trade-reporting charge and no cost for real-time market data.

"Chi-X participants continue to enjoy price improvement and lower trading costs, and we remain committed to providing the European trading community with the benefits of our faster, cheaper and smarter model," says Peter Randall, London-based chief executive of Chi-X Europe.

These cost benefits have appealed to a variety of high-frequency traders, as well as dealers keen to meet best execution requirements as stipulated under Mifid. "We aim to connect to as many trading venues as possible to provide best execution for our clients. Approximately 25% of Credit Suisse's flow in Europe is traded away from exchanges at the moment. If prices are better on alternative venues, then our order flow will be rerouted there," says George Andreadis, head of liquidity strategy in Europe for Advanced Execution Services at Credit Suisse in London.

Having watched the launch of these new facilities, exchanges are now beginning to fight back, with some slashing trading fees in an effort to appeal to algorithmic traders and statistical arbitrage funds. NYSE Euronext, for instance, reduced its fees by up to 30% for high-frequency traders on its European cash equity markets - essentially all stocks listed on Euronext spanning Amsterdam, Brussels, Lisbon and Paris - from July.

The new structure comprises four tiers: tier one has a EUR1.20 per executed order charge; tier two charges EUR1 per executed order with a minimum activity charge of EUR250,000 a month; tier three has a charge of EUR0.75 an order and a minimum activity charge of EUR400,000 a month; while tier four offers EUR0.50 per executed order, with a minimum activity charge of EUR600,000 a month. Users are only charged for the first partial order execution, rather than being charged for each partial execution linked to the same order. In addition, the existing order-to-trade ratio has expanded from 10:1 to 30:1, allowing traders to increase order flow capacity without incurring a transaction fee.

"This innovative pricing has been designed to take into consideration the development of new business flows from high-frequency trading that use automated or algorithmic strategies to benefit from market opportunities," explains Roland Bellegarde, head of European cash equity markets at NYSE Euronext in Paris.

Meanwhile, the London Stock Exchange (LSE) plans to cut its trading fees from this month. For FTSE 350 stocks, international order books and other liquid securities, the new structure will include a tiered credit scheme for liquidity provision based on the value traded by clients in each month. There will also be a simplification of charges for taking liquidity, with a revised tiered discount scheme based on value traded in each month. For all securities, the 7.5 pence execution change will be removed from both sides, while the one pence order management charge and the maximum per trade charge will also be eliminated.

"We believe the new shape of this tariff structure will capture the important growth arising from the major shift towards statistical arbitrage and algorithmic trading in UK equity markets," says Clara Furse, chief executive of the LSE.

In addition to cutting prices, exchanges are developing new trading platforms to capitalise on fresh business opportunities. For instance, SWX Europe, the London-based securities exchange owned by SWX Swiss Exchange, launched a dark pool service in August for Swiss equities, called SWX Swiss Block. This will run parallel to the exchange's visible order book.

Elsewhere, the LSE and Lehman Brothers are partnering to create a dark pool called Baikal, which they expect to go live in the first quarter of 2009. Baikal will operate as a separate company, and there are plans to have other partners join in the ownership structure. It will provide access to equities across 14 European countries via connections to at least 22 trading venues.

Lehman Brothers has been operating its own internal dark pool, called LX, since April 2007 for equity trades, but this is targeted only at the firm's clients and proprietary traders. John Lowrey, head of European electronic trading at Lehman Brothers in London, says: "We saw LX as providing value to our customers, but it would never be any larger than Lehman Brothers. Meanwhile, the LSE was considering alternative modes of trading to its traditional 'lit' trading. We saw the LSE as a perfect partner to develop a pan-European dark pool to aggregate liquidity."

Even though a major dealer is involved with Baikal, the platform will not operate with any market-makers. This contrasts with platforms such as Equiduct and Nasdaq OMX Europe, which plan to use a 'maker-taker' pricing model, whereby firms are paid to provide liquidity and charged for removing liquidity from the platform. Baikal works by matching trades and managing orders, and uses algorithms and a smart order router to distribute liquidity to other trading venues if there is a better chance of execution there.

"Liquidity is already fragmented. Baikal will pull together liquidity from dark and lit trading venues. It will be suitable for block trades, algorithmic traders and risk offset trades, and host a variety of users," says Lowrey.

Meanwhile, NYSE Euronext has been developing Smartpool, its dark pool for block trading of equities, since October 2007 and plans to launch sometime between September and October this year. Smartpool is being created in partnership with HSBC and BNP Paribas, while NYSE Euronext will create and run the platform and hold a 51% stake in the business. More banks are expected to join the initiative.

"The reason it was created was because we noticed there was a change in how firms were trading equities. There was an increase in the volume of trading but a decrease in the size of orders. To avoid fragmented trades and partial execution, we created Smartpool to match large trades in the dark," says NYSE Euronext's Bellegarde.

Meanwhile, some firms are looking to extend the idea to derivatives markets. Eurex launched its multilateral block trading system for equity options in July, which expands on its established bilateral block trading service. This allows a buyer or seller to enter block trades with several counterparties, instead of entering separate bilateral block trades. "We have seen a growing interest in the service since its introduction in July," says a Eurex official.

In addition, Credit Suisse plans to launch Advanced Execution Services Options, the bank's suite of algorithmic trading strategies, tools and analytics for options, later this year in Europe. The service allows investment managers to carry out trades for options using automated algorithmic trading strategies that have been developed in-house by the bank's quantitative analysts and traders. This incorporates the use of a smart order router to select liquidity venues that have the best chance of executing trades at the lowest price, spanning both displayed and dark pools.

Meanwhile, a consortium of major dealers and brokers is believed to be developing a derivatives trading platform, Project Rainbow, to compete with Europe's exchanges. The consortium is said to include Barclays, Deutsche Bank, Goldman Sachs, JP Morgan, MF Global, NewEdge and UBS. Similar to Turquoise for equities, the aim is to lower trading costs.

However, not everyone agrees new trading platforms for options will be a sure-fire winner, noting that exchanges already provide relatively low-cost, efficient trading of equity options. "We have so far not seen demand for a dark pool block trading service for derivatives contracts. There are already some exchanges, such as Liffe's BClear platform, which execute bilateral block trading. Maybe if Mifid extends to derivatives, we might see more demand for a dark pool derivatives trading venue," says Bellegarde.

Others agree, noting the majority of derivatives trading is currently conducted off-exchange. "Futures exchanges are already pretty efficient, so I am not sure if a host of new derivatives trading venues would bring prices down much further," says Instinet's Balarkas. "A large proportion of European options are traded off-exchange at the moment, so there is some way to go in the development of options trading."