Over the past couple of years, continuous lit intra-day equities trading has been declining – with 2023 reaching a record low as one of the worst years for lit orderbooks since 2016. Laurie McAughtry explores the impact of continued liquidity fragmentation on European markets – and its implications for market structure moving forwards.
According to big xyt data, 2023 ended with a steep decline in intraday lit continuous trading, i.e. on orderbook trading excluding dark pool and auction activity. This has reached a new low of 37% of the overall market, a drop of 12% since the MiFID II implementation. Q3 and Q4 lit continuous volumes were down 20% and 11% respectively from the historical average.
What the data seems to suggest is that lit intraday electronic trading is being pushed out to other channels – giving up substantial market share to both auctions, and off-orderbook on-exchange trades – with negotiated block trades taking place over the phone or via chat between two parties, usually two brokers, acting on behalf of a buyer and seller, respectively. The trend began in 2021 with an increase from around 15% of the overall market in 2020 to 21% in 2022 and a further notch up by 0.4% in 2023. So although the trend has slowed down somewhat, off-orderbook manual trading is still growing… and showing no signs of reversing.
“Feedback from our clients points to some recent shifts in trading behaviour to go ‘off-orderbook’ due to the lack of intraday liquidity, and if so, that would reduce the market’s overall accessibility to natural flows through the orderbook. This is particularly curious because we do not observe any substantial patterns in widening orderbook spreads or touch sizes (both are a mark of liquidity); we are just seeing less traded volume,” noted Richard Hills, head of client engagement at big xyt.
Direction of travel
So what are the dynamics at play? Trading a large position in the orderbooks without incurring undue market impact means staying more or less in line with the liquidity currently shown on the touch. Because flow has migrated to the later part of the day and the closing mechanism, it has become increasingly harder for a trader to find a substantial natural counterparty in the lit orderbooks. It makes sense, therefore, to make greater use of bilateral, manually negotiated brokered trades where a substantial proportion of a position can be traded quickly between two counterparties and with little market impact.
“In my view, the drift to the close and increase in off-orderbook negotiated trading are linked,” agreed Hills.
“Meanwhile, dark pools, periodic auctions, and conditional venues play a critical role in helping larger traders to interact with more potential counterparties without revealing their hand, while also having the effect of teasing liquidity out into the lit orderbooks.”
A good example of this is the new lit-dark sweep order types that allow a trader to access both types of venue with a single order. But of course, these are restricted by various rules. One that gets little attention is the ‘mid price lock’ that forms part of the reference price waiver – which generally doesn’t exist outside Europe – and which, some suggest, could be having an unintended detrimental impact on price formation.
“Over the very long term, even looking back 10-15 years, we’ve seen a drift towards electronic trading, towards electronic algorithms, smart order routers and so on. This is the reverse of that trend. And that’s what makes it very interesting,” said Hills.
The buy-side view
“From our perspective, lit market share has decreased quite significantly. Within that, it’s the MTF lit orderbooks that have suffered the most,” commented Paul Squires, head of EMEA equities trading at Invesco. “Looking at the data for August 2023, for example, the MTF lit orderbook business was at a 16-month low, and actually close to a five-year low. However, within the lit market share itself, primary lit was actually at its highest since June 2022, so there are some interesting splits. But in aggregate, lit is way down.
“In 2019, lit accounted for around 62% of market share, and remained around the same level in 2021 and 2022. In 2023, however, it dropped down to around 55-56%. It’s definitely on a downwards trend.
“Lit venues tend to be the most toxic, for us, because there is less control over the liquidity that we interact with. It’s almost a venue type of last resort. If you strip out the regulatory mantra about supporting the exchanges (i.e. the idea that lit venues are better because they make price discovery easier and it’s a cleaner, fairer venue, etc), our experience has actually always been that lit venues are where you need to apply the most care. You get more latency arbitrage, for example, which can be more easily controlled on dark venues and periodics.”
Internalisation of the close
Some market participants have pointed out a longer-term trend of alternatives to the close, often moving towards channels such as systematic internalisers (SIs) instead, as the high levels of activity in the closing auctions bump up price. Is this related to the lit decline?
“Periodic auctions have gone from sub-2% to almost 4% recently, and that’s a big increase. It might not sound like much but that’s a doubling from where it was,” commented Squires.
“The aggregate headline numbers for SIs also don’t indicate much change, but it feels to me like there is more being done by SIs. And the data can be a little skewed or misrepresented depending on whether you trade OTC and report it on venue or not. We use principal risk from some of our brokers, and that’s an important advantage for us. In fact, our single largest venue is a bank SI.
“I would say the more interesting evolutions over the last 18 months or so have been in terms of new liquidity providers for us in the SI space – where we have been able to carve out direct relationships rather than via a broker as intermediary.”
Internalisation and risk provision around the close is still dominated by Tier 1 investment banks and brokers, and there are good reasons for that. “If achieving the closing price is a key target for an investor, and a broker has capacity to take that trade on risk ahead of the close then that can be attractive,” explained Simon McQuoid-Mason, head of equity products for the UK & Ireland at SIX Swiss Exchange. “The broker will try to unwind that risk in a way that is cost effective and/or profitable for them – which means beating the closing price. Theoretically, this should add to liquidity during continuous trading if the risk is being unwound on orderbook. However, there are also off-book mechanisms now providing meaningful liquidity during continuous trading which have the opposite effect. So investors have optionality in how they trade chunks of liquidity both intraday and around the close via alternative execution mechanisms.
“If participants are trading low-liquidity securities, we’ll tend to see an increase in the use of dark trading mechanisms and auctions especially for larger orders. However, for very illiquid securities investors will tend to source liquidity wherever they can get it. Again, this means in times of low liquidity, dark or auction is usually going to bump up in less liquid names.”
Liquidity pressures
The fragmented liquidity landscape in Europe right now and the general constraints on available liquidity, especially in the equities market, are also influencing the trend.
“There has been a drain away from liquidity and continuous trading. But when volumes are bad, and you’ve got less liquidity on the market as a whole, typically market impact and pricing impact is exacerbated. Where there is thin liquidity, you can have a greater impact when interacting with orderbooks. Fundamentally it’s a low volume market right now, so people are using all the mechanisms that they have at their disposal to get relief,” noted McQuoid-Mason.
“The easiest way to confirm that there has been a drain out of continuous trading is to look at ADV traded in the auction. And that’s grown, in particular over the last 6-12 months. There are two ways of looking at that. Are people trading the auction more, or are they trading continuous less?”
The current liquidity squeeze might be encouraging more bilateral liquidity provision to plug that shortfall, but this could be self-harming if this leads to even less publicly available liquidity. “We could also be seeing a two-tier market playing out here with those able to access this bilateral liquidity and those that either can’t or don’t see preferential pricing that others do – hardly a great outcome either way,” agreed James Baugh, European head of market structure at TD Cowen. “And regardless, it becomes increasingly difficult for the sell side to provide best outcomes for those end investors if we don’t have a better handle on what’s being executed and where.”
Price formation
Within the SI category, what is also growing is smaller trades, and those smaller trades are being executed electronically. You can trade bilaterally on risk, and that order flow is no longer going on to the orderbooks – but it’s still participating in price formation because those prints are still getting published to the market.
“Fair and transparent price formation is the lifeblood of liquid markets. Whether it’s continuous trading or the closing auction, it is hard to argue that it is not integral to the trading ecosystem,” urged McQuoid-Mason.
But…
“In practical terms, why is effective price formation important to execution quality?” asked Hills. “The answer is that if we are able to assume that most natural buyers and sellers are present at the same time and we can easily interact with that liquidity, the price is likely to be reliable at least in the near term. If there’s a block taking place away from the orderbook, and it’s been negotiated at a different price, then eventually that information is going to come into the market and then price is going to move.
“It’s a long-term concern for everybody, but what we’ve really got to ask ourselves is whether the lit orderbook, and everything that goes around it in terms of the regulation and the dark pool caps and all the other aspects of dark trading restrictions, such as only being able to execute at the midpoint, is what we really need. Or does that need to be reviewed?”
Baugh added: “If we are seeing a dilution of lit business on a primary venues, then there are questions to be asked around whether or not we should be operating within those confines, and [whether] we should be using primary reference price, when for example matching at mid-price in the dark MTFs.”
Regulatory challenges
The regulatory environment appears to have hindered transparency in certain respects. A key objective of MiFID II was to reinforce the function of the lit continuous trading sessions during the day as the key tool in price formation through the Share Trading Obligation and other means such as the imposition of restrictions to dark trading and bilateral automated execution in broker crossing networks. On that basis, it would be fair to expect that the intraday lit orderbooks would at least maintain or grow their market share. Yet from the start of MiFID II in January 2018, data would appear to show a consistent decrease in the lit continuous trading mechanism, except temporarily during the volatility provoked by Covid and the crisis in Ukraine.
“We’ve noted a near 20% growth in inaccessible liquidity post-MiFID II,” noted Baugh. “That number encompasses OTC, off-book on-exchange and SI business. This is obviously not what the regulator had hoped for, given MiFID was all about transparency and trying to encourage more business onto lit venues. It would seem to have had the opposite effect.”
“The regulatory direction now, with the UK looking to strip out things like double volume caps and making SI quotes more flexible, is very helpful,” agreed Squires. “And it illustrates that there were perhaps elements of MiFID II that were not very friendly towards the end clients.”
Is change needed?
“What the industry is really interested in is accessibility of liquidity,” said one buy-side trader. “If you’re a buy-side trader and you put a big trade through your broker, you can see the orderbook is currently liquid, but then conditions change, and as soon as you start to trade the liquidity dries up. Where is that liquidity going? Was it real liquidity in the first place?”
Electronic trading in any type of automated orderbook – lit, dark or auction – has maintained a steady share of around two thirds of market liquidity for five years, even in 2023, with the auctions soaking up 4% extra market share since 2018, according to big xyt data. Meanwhile, off-orderbook, manually negotiated trading has risen 7% over the same period, and together they broadly match the 12% lost by the lit continuous trading mechanisms.
“We have to ask the question: is the current market structure fit for purpose and does it put any obstacles in the way of the main objective of encouraging natural liquidity providers from using the lit orderbooks as their default trading mechanism?” said Hills. “Perhaps the next step is to remove the mid-point peg rule for dark pools that effectively penalises their use and may hinder electronic trading altogether. This aspect is unique to the European region.”
The problem is, what happens at the logical end of that road?
“If we suddenly turned the lights out across Europe, and everyone was trading in the dark, how would you know the price of any security? Your potential to be adversely selected goes up significantly,” warned McQuoid-Mason.
“It’s a balancing act in my view. You can’t say that these alternative mechanisms are bad because they do facilitate different types of interactions for a kaleidoscope of different objectives. But if it’s completely to the detriment of public orderbooks, that’s not helpful either – as venues do have a measurable impact on the price formation process which helps to determine the market’s best interest. So it’s a tightrope that needs to be walked.”
True liquidity should be publicly available for all. “The best outcome, I think, when executing business, is to do so in a multilateral environment,” said Baugh. “It doesn’t matter whether it’s dark or lit, but multilateral, where you can manage for impact, where you can mitigate some of the price moves and reversion. When you’re just matching on a bilateral basis, you simply don’t know what the intentions are of your counterparty and whether you really are getting the best outcomes.”
©Markets Media Europe 2024
