The last decade has been an era of unprecedented change in the affairs of stock exchanges. In developed countries, the exchange landscape has been transformed from one in which every country has its own member-owned 'club' to one in which there have been demutualisations, mergers, new exchanges, closures and every variety of corporate transaction: joint ventures, licensing arrangements, attempted hostile takeovers.
The only thing that has not happened, in the cash equity markets at least, is a successful battle for another exchange's liquidity. But it is not for want of trying. A number of exchanges have sought to create liquidity pools to draw volume away from the established player in a particular market, but none has been successful. This has given rise to the question as to whether such 'takeovers' of liquidity are possible and the current wisdom is that they are not.
The purpose of this article is to seek to understand the inherent and the engineered defences that an exchange can employ to protect its territory. In analysing this subject, it then becomes possible to see under what circumstances, if any, it is possible to 'poach' liquidity from another exchange. I base my comments partly on my experience as CEO of Tradepoint (now virt-x), which has been the most strenuous (failed) poacher of exchange liquidity, and partly on my subsequent career as a strategic management consultant advising exchanges and their members. Ten possible defensive characteristics or tactics are set out below.
Membership networks
Exchanges have members (even after demutualisation). One important structural defence that an exchange possesses is its membership. Thus the London Stock Exchange (LSE) has as its members all those firms that desire to trade UK equities (and its other products). It does not have all those firms that wish to trade, for example, French equities. Nor, for that matter, does Euronext-Paris have all those firms wishing to trade UK stocks. This point is nothing to do with the loyalty or vested interest of the membership, merely their defining nature.
As regards institutional brokers, all major exchanges by and large count all of the major institutional firms as members. However, the distinction comes in the retail world, where, for example, Barclays Stockbrokers is not a member of Euronext-Paris, nor is Paris-based Cortal a member of the LSE. Although retail volumes are small relative to institutional, in most markets they have a disproportionate impact on the price formation process by providing granularity: ten separate 5,000 share sell orders fill an order-book more than one 50,000 share sell order. Since membership networks bind retail order flow more to its home market, the LSE, for example, is structurally in a weak position to poach French equity liquidity. And this is self-sustaining, as without credible French liquidity, it is unlikely to be able to attract Cortal as a member. Think chicken and egg!
Interestingly, the LSE, by being only tangentially involved in retail equity trading, is in a position of relative vulnerability. The providers of liquidity in the Stock Exchange Electronic Trading Service (SETS) are, in the vast majority of cases, members of Deutsche Börse and Euronext. Institutional business is potentially more moveable and contestable.
What would erode this defence? It would be greatly weakened if retail investing became a pan-European business in the way that the institutional business is. The fact that it is not was the principal (and highly predictable) cause of the failure of Jiway. Alternatively, the defence would be weakened if retail trading ceased to be important in the price formation process (as in London).
Connectivity
When I was CEO of Tradepoint (now virt-x), my team and I spent a considerable amount of effort 'selling' the exchange to traders. However, although they all signed up as members, they did not use the market. One of the major reasons was that access to the market was not connected to their trading systems. Even when better bids or offers appeared on our order book, the (momentarily) inferior prices available on the LSE were hit and lifted. Potential users simply could not see nor easily access the market. If the Tradepoint 'terminal' was at the end of the desk, it was not accessible.
The solution (which we realised very early on) was to get Tradepoint integrated into the main order management systems (OMSs), like royalblue. This proved to be easier negotiated than implemented! Royalblue were keen but the traders had so many other higher priorities and we could not demonstrate the required liquidity (because we were not already connected). Think chicken and egg again!
This inertial defence may have been weakened over the last five years, as exchange connectivity has become much more 'plug-and-play'. If it had merely been a flick of a switch by an OMS vendor to integrate Tradepoint back in 1999, it would have happened.
Organisation of dealer desks
My consultancy was carrying out an assignment for a client a while ago into the viability of pan-European sector index futures (and options). It was an interesting assignment in many respects but one of the key findings was that the natural usage of such a product - trading desks hedging their sector exposure - was frustrated because, with one exception, the desks were not organised along sector lines but rather on a national basis.
The implications of this for liquidity poaching are clear. If I trade, say, French equities, I do all my trading with Euronext-Paris. I know how the rules work and the settlement happens uniformly. To start trading French equities on SETS requires me to change what I do.
If, on the other hand, I trade Pharmaceuticals, I need to have access to at least London, Paris, Deutsche Börse, the SWX and Stockholm. I am used to trading with slightly different rules, pricing and settlement and have become comfortable with it.
In the latter circumstance, the inertial barriers to liquidity poaching are greatly reduced because our notional trader feels equally comfortable in any market structure (and he has access to them all).
This 'national desk' defence has weakened but will weaken further as more firms organise their trading on a pan-European basis.
Regulatory effects
Regulatory effects can have a big impact on trading destination and the contestability of liquidity. The most obvious example of this is that some countries (notably France, but also Italy, Holland and Spain) have regulations or laws that entail that local firms trading local equities outside the national order-book are classed as trading 'off-exchange'. This has the effect of invalidating the trade from a regulatory perspective with resultant sanctions in the form of fining and/or suspension.
The European Commission is seeking to address what it sees as inappropriate constraints to the free flow of financial services throughout the EU and, in this capacity, is actively considering loosening the current Investment Services Directive in this context. It remains to be seen (at the time of writing) whether it will be bold enough to outlaw such anti-internalisation provisions as these, which, to Anglo-Saxon eyes, appear to be related more to protectionism than to investor protection.
In the meantime, where such laws or regulations stand, they are probably the most formidable of all barriers to the contestability of liquidity.
Settlement integration and custom
For this subject, I return again to my experience at Tradepoint. Tradepoint was a real pioneer in the area of clearing and settlement. It had a cleared trading model well before any major European equity exchange even considered the idea. Settlement was guaranteed by the London Clearing House (LCH) and happened with remarkable smoothness and with minimal risk. We introduced netting to enable people to reduce costs yet further.
However, throughout that period, the LSE was giving up counterparty identity in SETS so that the parties to the trade could settle with each other in Crest. Tradepoint had a vastly superior settlement model, yet settlement was a major drawback for Tradepoint, because it was different. An inferior but more familiar settlement model would have worked much better. If the back office is complaining about the hassle of clearing or settling through a non-standard channel, the trader will take notice (I would not want to overstate this point!).
Euroclear already offers a pan-European settlement model that very few firms use (apart from those markets where Euroclear is the Central Securities Depository (CSD) because even the biggest firms want to settle where they expect their counterparties' stock to be. It is no use my moving my Vodafone from Crest to Euroclear, if I will only have to move it back again to settle the next trade.
Another settlement-related defence is the often-cited one of vertical integration. If national regulators mandate settlement in the national CSD, or allow the dominant exchange to so mandate, or simply the exchange fails to offer any alternative clearing or settlement solution, then poaching liquidity becomes harder and, equally importantly, is seen to be harder. Post-trade processing becomes 'tied' to the dominant exchange, further locking in customers and diminishing contestability.
As Clearing becomes a standard component of the post-trade process (thus potentially unlinking each party's final settlement destination) this defence becomes weaker - at least for the more horizontally-oriented exchanges. To the extent that there is consolidation amongst clearing houses, as with the much-rumoured merger between Clearnet and LCH, this defence is further reduced in impact.
Confidence in liquidity
During my time at Tradepoint (and even more so after I left), we encouraged members to post liquidity on the order book, by means of regulatorily-approved incentives. We would pay members to post bids or offers if those were subsequently traded against.
In any ordinary business, such an incentive would have a significant effect on customer behaviour. However, in this case it made no difference at all. Members' perceptions of the likelihood of trading were so much lower in Tradepoint (relative to the LSE) that they were quite rationally prepared to forego the incentive in favour of the faster and more likely execution.
In other words, they had high confidence in the liquidity of the LSE and little confidence in that of Tradepoint (or virt-x, where the scheme involved receiving warrants to shares in the exchange). This is again a chicken and egg issue, as, without large volumes of trading, it is virtually impossible to attract the liquidity that creates the confidence of trading.
At this point, it is worth digressing into the world of derivatives. For here we see perhaps the only examples of liquidity being successfully contested by another exchange.
Readers will be aware of the cataclysmic loss of the business in German Bund futures in 1998 that nearly caused the demise of Liffe. It is worth looking at this experience to see what lessons it provides for the debate in the context of cash equities.
There were a number of factors in the Liffe/Deutsche Terminbörse (DTB) (now Eurex) tussle that contributed to the transfer of liquidity. These included:
- the lower-cost nature of the DTB system compared to the Liffe floor;
- the sense that many market users then had that Liffe floor traders were gaming and front-running their orders;
- the faster more-controllable access offered by screens;
- the hurt national pride of the German financial community at having to trade their government bond future in London and
- the mould-breaking approval by the Commodity Futures Trading Commission (CFTC) enabling the DTB to offer direct terminal access to members' desks in the US.
As a close observer of the situation at the time, my view was and remains that all factors contributed but that the swing factor - the one that gave users confidence in DTB liquidity - was the CFTC concession. DTB officials pointed out to me at the time that the impact of this alone was to transfer about 20% of total market share within a month.
However, in discussing the matter recently with someone who was very much at the centre of Liffe decision-making at the time, I was told that the level of dissatisfaction at the behaviour of Liffe floor traders was the trigger. All that was required was a viable alternative and the DTB provided it.
There are analogies (and differences) with the so-nearly successful challenge mounted by SEAQ International to European equity markets in the late 1980s and early 1990s. SEAQI was, for a while, vastly superior in terms of liquidity and dealing flexibility and, notwithstanding a strong 'membership network' effect (see 1 above) working in favour of the defenders, nearly overcame a number of European bourses. Unlike Liffe, however, these Exchanges responded sufficiently quickly to recapture their business by eliminating the structural advantages that SEAQI had built up (and, indeed, by moving to open order-book structures, greatly surpassed SEAQI in terms of access, transparency and lower trading cost).
Another instance of contested liquidity is the ongoing battle between US-listed option exchanges. In an already crowded market (the Chicago Board Options Exchange (CBOE), Amex, Philadelphia and the Pacific), a new entrant arrived in 2000: the International Securities Exchange or ISE. Since its launch, the ISE has increased its market share of single stock options to around 24% and is now second only to the market leader with (a much-reduced) 28% - the CBOE.
How has the ISE managed to do this? Its distinctive features are as follows:
- It is the first (and so far only) entirely electronic options exchange in the US - this makes access immediate and allows potential market-makers without a physical floor presence to take part.
- It has encouraged corporate market-makers rather than locals.
- It has implemented preferencing rules allowing broker members to route order-flow to (tied) market-makers when offering the best price.
It is worth pointing out that option liquidity (being derived from cash market liquidity) is much more easily 'manufactured' than cash equity liquidity. Thus a new exchange setting up can invite proprietary trading firms to offer liquidity (on a concessionary basis in terms of trading fees or inducements) and can be assured that users will have confidence in its liquidity.
What are the implications of these two instances? Firstly, in both cases the model employed by the challenger was significantly superior in one or more respects (for example, technology or regulatory access) than the incumbent. This seems to be a necessary but not a sufficient condition.
Secondly, in both cases, there was confidence in potential liquidity. In the case of the Bund future, the standardised nature of the contract acts to concentrate liquidity, ensuring sufficient to execute the largest transactions. In the ISE case, the product, though anything but concentrated, lends itself well to market-making as a generator of liquidity. This too seems to be a necessary but not a sufficient condition but both together may result in sufficiency.
The current European cash equity market exhibits neither of these two characteristics as there is both relatively little differentiation (all order books) and very little formalised liquidity provision (especially in blue chips).
Nationalism and politics
Anyone who knows Europe at all well knows that the European dream of a united federal state is highly unlikely to be achieved this century. Recent diplomatic issues have shown that Europe is and will likely remain a group of nation states with strong national identities.
To an extent, this national identity issue has broken down in the commercial world but stock exchanges are curious animals and still excite considerable national pride.
This effect is rather subtle and I would not wish to overstate it but there exists what I call the 'City Club' phenomenon, after the august luncheon institution on Old Broad Street. Imagine that you are the CEO or Head of Equities of a major trading firm and you are considering going public about pulling all of your business out of the LSE and moving it to, say, Deutsche Börse. How are your peers going to respond to you next time you see them at the City Club? It would not be the decisive factor in your decision but it would be a factor. And if you think that it would not be a factor in London, think about Frankfurt or Paris!
Another factor is what I call the patronage effect. There was a particular (anonymous) head of trading at a fund manager who had been a consistent public critic of the LSE and fan of Tradepoint. He had joined Tradepoint's Market Advisory Panel. However, one day, as part of one of its market consultation exercises, the LSE, rather courageously and very shrewdly, invited this person onto its own Secondary Markets Committee. Overnight, this same person's views on the conference circuit (on which he was a regular performer) changed dramatically. Perhaps it was because he now understood the LSE better, from the inside, as it were. Then again perhaps it was that he was responding to his newly-enhanced status and new vested interest. Patronage can sway allegiance. We are, after all, human - with egos and a desire for recognition!
As European business culture changes, this factor will weaken. The existence of Euronext as a (theoretically) multi-national exchange will itself cause this factor to weaken as market professionals slowly come to see exchanges more as ordinary businesses and less as national monuments.
Institutional behaviour
Another interesting feature of the Tradepoint story relates to the institutional angle. Uniquely in exchange history, Tradepoint tried to woo institutional investors to be active direct members. Many attributes of the exchange were driven by institutional requirements (from the tariff structure to the agency contractual structure and clearing arrangements). Tradepoint offered transparency and a level playing field at a time when opacity and slopes were the prevailing service model. It should have worked a treat, yet Tradepoint was not successful.
When we asked institutions why they did not use this market, which, unlike any other, was designed with them in mind, their reply quite credibly pointed out that we did not have liquidity (that chicken and egg again!) Yet, whilst this was abundantly true, it was not the whole answer because, with the opportunity to create liquidity themselves (where else does liquidity come from if not from investor supply and demand?), we were trying to 'liberate' them from the bid-offer spread.
On reflection, we were forced to conclude that institutions needed the set of services that the brokerage community was offering them. They needed (and still need) hand holding, they needed advice and research (despite their protestations to the contrary) and they needed such liquidity as was being offered ('I'll start you off in a quarter if you can leave the rest of the order with me…'). And they also needed corporate entertainment (but not to any indecent extent that would alarm the compliance officer). Finally, in some (but by no means all) cases they needed to relinquish responsibility for trading.
Let me explain. If I am a fund manager's dealer and I have a very large block of stock to buy, I can manage it myself or I can give it to a broker to manage. If I do the latter and he makes a mess of it, I can scream and shout at him (after the fund manager has done so to me) and punish him by not dealing with him for a few days. However, if I am managing the order myself and make the same mistake (and, if anything, I am more likely to, because the broker is the expert at trading and has access to more market information), then I have no-one to shout at and blame. Career is over! Especially so if my trading technique is novel and non-standard. Using a broker is like buying an IBM: no-one ever got sacked for doing it.
This may or may not be a defensive tactic of exchanges but it certainly explains why disintermediation is not currently a worthwhile or successful means of attack! There is no evidence that this will change, notwithstanding the increasing skill of buy-side trading desks. What is happening is greater use of discount and direct access brokerage, especially by the hedge fund community, but this has only modest implications for liquidity poaching.
Lack of cost consciousness
Trading costs are difficult to calculate and to understand. As an investor I can see the commission charged because it is explicit and I can see the price at which I have dealt. However, I cannot see what I would have dealt at had I waited for five minutes (it might be better or worse) and I cannot know ex ante whether I would have dealt at all if I had tried to sell my stock patiently at the offer rather than hitting the bid (and paying the spread). This, incidentally, is one of the reasons why writing best execution rules is so fraught with difficulty.
In the boom, professionals on both sides (brokers and fund managers) were quite oblivious to costs of any description ('I need a Bloomberg because one of my clients has one!'). Nowadays, everyone is a lot more careful. However, it is still very difficult to be careful about costs that cannot easily be quantified, like trading costs.
Elkins McSherry or Plexus can tell me whether my own trading is more efficient than the next dealer's but how does that help me to decide how to handle the next big block? And are the differences a function of missed opportunity? The 'patient' trader will always have lower trading costs than the aggressive but he will also trade less often. If the fund managers' stock selection is above average, this could, in fact, cost the fund more in uncompleted trades and uncaptured performance!
Through all this, one thing is clear. Cost is not currently a big driver of trading destination. Exchange users will not place the order where the fee is lowest; they will place it where they can get the best price or the most certainty of execution. Cost is thus an ineffective offensive weapon for exchanges.
Is there a need for change?
The last factor is the most difficult and is summed up by the question above. My final act as CEO of Tradepoint was to sell a majority stake in the company to a consortium of major brokers. My successor then worked very hard and managed to strengthen the consortium to include all of the major brokers, without exception. For the princely sum of GBP14m, this group of ten brokers owned around 60% of a 'small but perfectly formed' stock exchange, with a cost base of around GBP8 m per annum.
On average, each of the ten was paying that amount in fees to the London Stock Exchange alone, let alone to all of the other European markets for which Tradepoint had regulatory permission (through the Investment Services Direct (ISD). In the words of the crime novel, the Tradepoint consortium had the means, the motive and the opportunity to make a perfectly legal killing and make or save themselves a shed-load of money. Yet it did not happen. Why?
The first thing to say is that it was not a failure on the part of my successors. It was to a large extent a mixture of many of the above factors - incomplete membership networks (especially amongst retail brokers), incomplete connectivity (though since remedied), trading desk organisation, non-standard settlement (finally to be remedied in the next three months!) and politics.
However, I think that the biggest factor of them all was the sense that it was not the job of any single broker to transform the market. For any broker individually, trying to change the system is impossibly risky. Confidence in shared objectives with other major brokers was required. This confidence did not exist as different members of the consortium clearly had different objectives. Some were there just because they did not want to be left out. Others had national loyalties to potential losers. In the overall scheme of things, the money that they would have saved could have been quite large, but not relative to the fees that they could earn doing an IPO for, say, Deutsche Börse.
There were a few members of the consortium who tried to change their trading behaviour by instructing their traders to use Tradepoint where possible, but the report came back from the front-line that they couldn't because there was not enough liquidity! Oh for an egg or a chicken!
Is exchange liquidity contestable?
To say that the answer is 'no' would be to fly in the face of the Bund contract experience. However, what is clear from the above is that there are a number of significant factors, which, when interacting with each other, make exchange liquidity practically uncontestable, in the current circumstances.
Is this likely to change? Yes - the market is still in a state of flux and a number of the defences are being reduced or eliminated completely. However, a number of other defences remain and the weapons of attackers are blunt. In the European cash equity markets there are no expensive and opaque floor trading mechanisms like Liffe used to be, and there are no massive regulatory asymmetries like Eurex had in the US. Such circumstances are the exchange equivalent of strategic nuclear missiles. In any environment where more or less all exchanges have order books with similar rules, clearing structures that are much the same and tariffs and trading costs that are not highly differentiated, the attackers have bows and arrows against armour plating.
Does this reduce the case for and benefits of competition between exchanges? Definitely not. Were it not for competition of this sort - the threat of contested liquidity - exchanges would be the gentlemen's clubs that they were before SEAQ International and Tradepoint came along. In an era of exchanges as for-profit, publicly quoted companies with the considerable network effect defences they still possess, continued competition is essential to keep them focused on their customers.
