Equity Market Structure Takes Center Stage as MiFID II Drives Liquidity Shifts

Equity market structure is entering a new and more challenged era as the tug of war between major stakeholders reaches a fever pitch and buy-side firms gain a stronger voice in market structure changes. In Europe, this struggle is playing out in real time under MiFID II. TABB Group’s Tim Cave examines the three key trends that are reshaping European equities – and that reveal many of the current tensions in the market.

Market structure enthusiasts were in for a big surprise early in the New Year.

Two announcements with potentially significant ramifications for equity market structure emanated from the US this week. The first was news that Chris Concannon, president and COO of Cboe Global Markets – operator of some of the biggest equity markets in the US and Europe – was saying farewell to the asset class and joining electronic bond platform operator MarketAxess instead, as president and COO.

The migration of electronic equity specialists to fixed income to help automate those markets has been happening for some time – but this is arguably one of the most senior moves we’ve seen yet.

The second announcement was that an influential group of banks, retail brokers and market-makers were planning to launch a new US equity exchange, called Members Exchange, out of frustration at the power held by incumbent markets.

The two events are unrelated but signal that equity market structure is perhaps entering a new and more challenged era. The tug of war between major stakeholders – including regulators, exchanges, sell side, buy side and market makers – is reaching fever pitch as long-standing conflicts are removed and buy-side firms seek a stronger voice in market structure changes.

In Europe, this battle is effectively playing out in real time under MiFID II – the new trading rulebook which passed its first anniversary on January 3. In fact, MiFID II has been an initiator of changes worldwide – in particular, its rules on research unbundling, which are being adopted globally, are changing the economics of many brokerage businesses, forcing closer examination of costs in other areas.

With the first year of MIFID II behind us – allowing us to make some firm conclusions about liquidity shifts in Europe’s equity market – it is possible to observe many of the simmering tensions that played a part in the creation of the Members Exchange.

Below, we examine three key trends: closing auctions, periodic auctions and systematic internalisers.

Closing Auctions

Closing auctions have long been viewed as one of the last monopolies of incumbent stock exchanges. While MiFID I paved the way for new venues to compete with exchanges, closing auctions have remained largely unchallenged. This has remained the case under MiFID II, and in many cases trading fees during these periods have become even higher.

There has been strong growth in closing auctions under MiFID II, a continuation of a trend that has been going on for several years, driven by the rise of passive investing. Closing auctions accounted for around 21% of order book trading in European equities in December 2018, compared with around 15% on average during 2017.

This trend has not gone unnoticed by other venue operators, which are looking to develop rival end-of-day systems, and this is likely to be a key topic of focus and discussion this year.

Periodic Auctions

The rapid growth of periodic auctions under MiFID II, the almost immediate backlash from some exchanges viewing them as a dark pool cap dodge, and a subsequent regulatory review brought to the surface some of the tensions between various stakeholders.

The prospect of MiFID II prompted an innovative twist on traditional auction models in the form of order books that run up to several thousand very short auctions throughout the day. Known as periodic auctions, these platforms are “lit” venues from a regulatory perspective, but with relatively limited pre-trade transparency to help reduce market impact. They have become the perfect antidote to MiFID II’s dark pool caps and enjoyed a significant increase in equity volume this year.

[Related: “Europe’s Periodic Auctions Under the Microscope”]

Volumes on periodic auctions have seesawed around a little bit this year, picking up steam as the dark pool caps came into effect, and then levelling off as the first of those caps were lifted in September. They now seem to be settling down somewhat, accounting for around 2.1% of order book activity in December. Cboe Europe remains by far the largest periodic auction, with daily notional of €754 million during December 2018, followed by Aquis (€60.3 million), Sigma-X (€55.7 million), ITG Posit (€45.5 million), Nasdaq (€30.7 million), Turquoise (€24.3 million), and UBS MTF (€0.9 million).

While the regulatory review into periodic auctions is welcome – the manner and speed at which it has been initiated reveals the influence (for better, or worse) that some groups have over European policymaking. Some policy measures on periodic auctions can be expected, but it will be interesting to read the views of brokers and the buy side during the consultation process.

Systematic Internalisers

While MiFID II closed down one off-exchange channel for equity trading – broker crossing networks – it promoted another. Systematic internalisers, the regulatory channel for principal or risk trading, have grown significantly under MiFID II. While it was always expected that banks would register SIs under MiFID II, it was perhaps never originally envisaged that non-bank, electronic liquidity providers (ELPs) would do so with such vigor.

The regime is highly attractive to ELPs for many reasons. Some ELPs provided liquidity anonymously in broker crossing networks run by the large investment banks under MiFID I, which have been banned under the new rulebook. The new rules allow ELPs to provide liquidity to the buy side in a bilateral fashion, something that would have been unlikely a few years ago given levels of anxiety around trading with such firms. Perhaps most important, it offers a way to trade whilst avoiding exchange fees, which have risen considerably under MiFID II. The growing use of the SI regime has not gone unnoticed by exchange operators, which have pressured regulators to apply the tick size regime to SIs to create a more level playing field. Some exchanges have also increased fees on the data that SIs are required to consume.

To date, nine ELPs have registered SIs: Citadel Securities, IMC, Jane Street, Jump Trading, Hudson River Trading, SSW Market Making, Tower Research Capital, Virtu Financial, and XTX Markets.

Activity conducted through ELP SIs has steadily increased under MiFID II, with average daily notional increasing from €243 million in January 2018 to €1.1 billion in December, according to TABB Group data. We are tracking volumes undertaken by six SIs: Citadel Securities, Jane Street, Hudson River Trading, Tower Research Capital, Virtu Financial, and XTX Markets.

Expect these volumes to grow this year, as the buy side is getting more comfortable executing against ELP SIs, and the tensions between various stakeholders to increase as a result.

All these changes and more are covered in the December edition of TABB Group’s European Equities LiquidityMatrix™, which provides the industry with breakdowns of market share for each major equity execution channel, including lit venues, dark MTFs, block venues, periodic auction books and systematic internalisers.

TabbFORUM is an open community that provides a platform for capital markets professionals to share their ideas and thought leadership with their peers. The views and opinions expressed are solely those of the author(s). They do not necessarily reflect the opinions of TABB Group, its analysts, TabbFORUM and its editors, or their employees, affiliates and partners.

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