We are six months into a European trading and investment landscape redrawn by MiFID II. But it’s still too early to tell with any certainty where liquidity will flow. In truth, we may not have a clear picture even by the end of the year.
This is partly down to the sheer scale and scope of MiFID II, but also because of the staggered timetable for rolling out a central feature of this new landscape: systematic internalisers (SIs), the mandated mechanism for bilateral liquidity provision. Suffice to say, the high degree of uncertainty demands that all market participants keep their options open. To deliver competitive execution service propositions, sell-side firms must identify which SIs will support best execution by their buy-side clients, and develop the most effective way of sourcing SI liquidity on an ongoing basis.
Why the fuss? It’s true SIs existed under the original directive, but their enhanced role in MiFID II marks a very distinct departure and poses new challenges to the routing capabilities of banks and brokers.
Critically, SIs fill the vacuum created by MiFID II’s ban on broker crossing networks (BCNs) – which previously pooled internal sell-side inventory with that of external electronic liquidity providers (ELPs) – and dark trading limits, which entered force in March. But SIs not only represent a new channel for liquidity but also a new business model and a new mode of interaction between liquidity providers and seekers.
One thing we can be certain of is the diversity of business models. Through SIs, ELPs must now deliver liquidity directly, a development which may finally stop these firms being lumped together as high-frequency traders. Some ELPs have grown into global, multi-asset liquidity providers developing close bilateral relationships with sell-side firms, others deal in equities as a consequence of their core business, such as ETF market-making, with distinctly different aims and inventory in their SIs. There is diversity on the sell-side too, with some firms promising block trading opportunities from their automated central risk desks, dependent on the nature of their relationships and franchises.
It’s far too early to tell which models will offer the best performance to the buy-side and ultimately the end investor. After all, we don’t even know the full universe of SIs yet. While many ELPs and brokers have registered, sell-side firms will not be formally obliged to meet their MiFID II obligations until September, a month after ESMA issues H1 2018 trading data, thus establishing which firms reached the regulation’s volume thresholds.
A parallel ‘known’ unknown is how routers will interact with SIs. Whereas ELPs once provided undifferentiated liquidity to all buy-side clients of BCNs, several have decided to provide multiple tailored price feeds to individual brokers. This means a buy-side firm may be offered a different price by an ELP-operated SI, based on whether its order is routed via broker X or Y. Further, brokers might by wary of exposing their SI’s price feed to the routers of other brokers – and vice versa – for competitive reasons. As such, the interaction of routers and SIs is very much a new and emerging science.
At the same time, trading venues have not been standing still. Keen to capture trading volumes formerly accounted for by BCNs, regulated markets and multilateral trading facilities have been beefing up their appeal with new order types, periodic auctions and other innovations. Execution service providers will need to ensure they provide access to these liquidity channels too.
At Vela, we’re working closely with liquidity providers and execution brokers to support market transparency and liquidity access in the emerging new landscape. It will take time and effort to holistically measure best execution for buy-side clients in this new world. But it is already clear that investment in the technology infrastructure needed to transmit, receive and aggregate data will be a prerequisite to success.