Liquidity is increasingly hard to find thanks to post-crisis regulatory interventions in Europe, a new report suggests, recommending that firms enhance the flow of information between the buy and sell side to ameliorate the issue.
As a result of this liquidity crunch, investment banks are internalising their flows “more than ever”, intraday lit trading activity has seen steep declines, and the amount of non-addressable liquidity has only increased, the report outlines.
The report by The Realisation Group, Europe’s Liquidity Crisis: Why Knowledge Is Power For Buy-Side Participants, leans on the insight of Simon Steward of Capital Group, Evan Canwell of T. Rowe Price and James Baugh at TD Cowen to illuminate strategies investment firms can adopt to deal with the dearth of liquidity.
The report suggests that the buy-side should engage in “dialogue” with their sell-side providers in order to position themselves to take advantage of evolving market dynamics. “It has never been more important to fully understand how our partners access liquidity,” says Evan Canwell of T. Rowe Price.
After 2008’s financial crisis and the rollout of MiFID II, the report posits that sell-side firms, exchanges and other trading venues adopted practices that have been responsible for less liquidity and less market transparency.
From 2018 to 2021, the amount of lit continuous trading activity averaged between 50% and 60%, according to a report by Liquidnet. But by the end of H1 2023, that share had fallen to close to 40%, with record-low levels of lit continuous trading activity.
Additionally, increasing amounts of liquidity in the market are being classified as non-addressable, leading to bid and offer prices not being posted in venues or on mechanisms where investors at large can see or act on them.
Since MiFID II, there has been an almost 20% increase in overall trading activity reported to the market as non-addressable in nature, including over the counter (OTC), off-book on exchange negotiated trades (NT) and off-book Systematic Internaliser (SI) business, the report outlines.
“Internalisation is a major, if not the, driver of these changes in liquidity,” says Simon Steward of Capital Group. “The sell side is having to be more focused on cost considerations in terms of execution decisions as margins are increasingly challenged. However, maintaining the best outcome for our clients remains our key objective and our aim is to make sure that cost considerations do not inhibit this.’’
Sell-side firms have also increased their off-exchange activity, creating alternative mechanisms and offering more bilateral liquidity provision and closing auctions have also had an effect both on price formation during these periods and on what happens during the rest of the day. In addition, some of the closing auction activity is taking place off of primary exchanges, where liquidity may not always be addressable.
An increasing divergence of approaches in terms of dark trading between EU markets and the UK is also thought to be at play, with the UK recently outlining its own post-Brexit rules in response to the Share Trading Obligation (STO) under the Markets in Financial Instruments Regulation (MiFIR). The STO required that any EU trading firm interact only with venues considered as equivalent in terms of their regulatory framework.
“Whether an investment firm wants to understand how it should navigate closing auctions, how much flow it should allow with systematic internalisers, what it should do regarding differing regulatory regimes, or any of the other issues thrown up in today’s marketplace, it is clear that the buy-side will benefit from deepening and intensifying its dialogue with the sell side,” the report says.
Ultimately, it will be teamwork and enhancing the relationship between the buy side and the sell side that may help solve the liquidity crisis, the report concludes.
“We are very much in this ecosystem together,” Baugh says. “Forming partnerships and working closely with clients to gain a better understanding of market structure and liquidity challenges has never been more important. These collaborations and conversations extend beyond electronic and low-touch channels, encompassing high-touch and multi-asset engagement.”
© Markets Media Europe 2023
