Steve Grob of Fidessa explains how brokers, traders and exchanges can adapt to life under MiFID II.
If MiFID II increases regulation on broker crossing networks, what other options do brokers have to trade with minimal market impact?
It depends upon the shape any such regulation takes. It looks likely that MiFID II will introduce a new category of ‘venue’ called an OTF - or Organized Trading Facility - that will be used to describe Broker Crossing Networks (BCNs). This will help the market as a whole as it differentiates the client crossing activity of brokers from their other, discretionary, activities. In this latter case the broker is fulfilling its fiduciary duty to its client in other ways such as by risking its own capital in order to complete a client order. This is a completely different activity from the quasi ‘venue-like’ matching of two different client orders electronically.
BCNs are part of the non-lit trading category that also includes buy-side crossing networks such as Liquidnet, dark Multilateral Trading Facilities (MTFs), such as Chi-Delta or SmartPool, and bilateral Over-the Counter trading. Unfortunately, all of these very different activities are sometimes lumped together as ‘dark’ trading. The lack of clarity around non-lit trading is the cause of much confusion amongst the regulators, some of whom seem to think that all ‘dark’ trading is somehow bad, however, trading away from an exchange is often the only way that many investment firms can achieve their objectives without undue information leakage or price slippage.
What is really needed is a clear description of each of these non-lit categories so that traders know what they are getting into, how deep the water is and who else they might be swimming with. In this way, the investment community is free to choose the best way of completing its orders.
Where is the biggest opportunity for banks in this new round of regulation? How can European banks come out ahead from this, or is it a question of losing the least?
The banks have suffered as much as any other market participants. In particular, the lack of a clear consolidated record of post-trade information has made it harder for them to prove the efficacy of the millions of pounds they have invested in technology to help their clients navigate the new post-MiFID liquidity. Clearer reporting rules will also make it easier for them to rebuff the politically motivated criticism they have faced.
What role will technology have in ameliorating the effects of MiFID II? What solutions should firms consider in order to better cope with the shift toward lit venues and transparency?
Technology has and will continue to play a huge part in all this. One of the trends we are seeing is a convergence between algorithmic trading and Smart Order Routing (SOR) so that the process of deciding how to trade gets combined with where to trade. On top of this we are also seeing a greater propensity for the buy-side to fly these hybrid algos remotely.
How can European high frequency proprietary traders remain competitive if they are required to undergo public scrutiny regarding their algos and strategies?
The High Frequency Trading (HFT) community would certainly find life difficult if its algos and strategies were open to public scrutiny, although this would seem to be an unlikely outcome. Given that HFT represents such a significant proportion of European (and US) volumes it would be an incredibly brave move if the regulators sought to censor them in such a heavy-handed manner. In many cases, the HFT community is simply acting as electronic market makers and actually are increasing liquidity and reducing risk in markets. This is because they act as sellers when there are no natural buyers and vice versa. On the other hand, there is a perceived concern over what can happen to markets if their algos go wrong or misfire. The first people to suffer in any such eventuality, though, are the HFT firms themselves, so it is not in their interest to be careless in this area.
Nevertheless, mistakes can happen and most HFT firms would accept the idea ofcircuit breakers being introduced at the exchange level. This is where the ‘fuse box’ needs to be and it is right that the exchanges bear the cost of this as they are the ones making money selling space to the HFT players in their co-location centres. Ultimately, the responsibility for maintaining an orderly market must rest with the venue rather than the participants. If they build faster and faster racing tracks, then they surely have a responsibility to erect and maintain suitable crash barriers.
Will a European Consolidated Tape really reduce costs for trading and research and how will exchanges replace this revenue stream?
The term European Consolidated Tape (ECT) has taken on a variety of different meanings. In terms of a pre-trade European Best Bid and Offer feed, this issue has been fixed for sometime by the vendor community. Most vendors provide customisable feeds that allow traders to see a ‘virtual’ market that reflects only those venues that are part of its best execution policy. This is obviously different from the US situation where a National Best Bid and Offer is mandatory for the venue-centric Reg NMS system to function properly.
The real issue concerns post-trade and this is critical for demonstrating best execution and finding effective answers to Transaction Cost Analysis. The reason this is tricky is that each venue has developed its own syntax for describing different trade types and so often you see one code meaning different things and vice versa. On top of this is the fact that the current OTC reporting regime leads to a certain level of duplication with trading that has already been reported on lit markets.
So, in summary, some form of ECT would definitely reduce research/analysis costs and, more importantly, increase transparency. The other issue concerns the impact of an ECT on reducing the cost of market data for the industry as a whole. Currently there is a huge discrepancy in market data fees ranging from the MTFs, which make it available at no charge, to the primary exchanges which some people feel charge too high a fee. As the market share of the primaries reduces it seems unlikely that they will still be able to justify their current pricing policies. A number of market participants have argued that if they are only getting 50 or 60% of the true picture from a particular exchange then why should they still pay 100% of the market data fee.
Finally it would be great if the media as a whole adopted some form of ECT as this would prevent potential misreporting of actual volumes as often only the primary market centres are referenced.