Thomson Reuters - Tackling the liquidity challenge

23 February 2011

By Stephen Wilson,
Global head of exchange traded instruments,
Thomson Reuters

We all know that traders need liquidity and their only thought is how to get their order done with minimal market impact - i.e. not showing their hand to the rest of the market. However, it is getting increasingly difficult for them to do so. Stephen Wilson, global head of exchange traded instruments, Thomson Reuters highlights these challenges and what tools are available to help traders thrive in this new era.

Since 2005 in the US when Reg NMS came into effect and 2007 when MiFID regulation in Europe hit, the number of trading venues carrying orders has exploded. If we use Thomson Reuters Equity Market Share Reporter (Fig 1), our liquidity fragmentation analysis tool and focus it on the UK, we can see that traders now have 29 different trading venues to choose from - at the same time the LSE’s share of its own market the FTSE 100 has almost halved to around 50 per cent in three years.



Fig.1

According to Celent (1), two years after MiFID opened up trade execution in Europe, a trader is now faced with finding meaningful liquidity across 22 Exchanges, 27 MTFs, 24 regulated dark pools and nine broker internal crossing networks. The picture is even more confusing when you find that, according to TABB Group (Fig 2) only 65 per cent of reported turnover in UK equities in 2010 represents meaningful liquidity you can ‘hit’ - 35 per cent is trade re-print noise.



Fig.2

But fragmentation is not just a regional trend, it is global. In Canada, the Toronto Stock Exchange is starting to see a similar pattern in its market share falling from 98 per cent to 66 per cent (Fig 3) as ATS venues such as Alpha Trading and Chi-X Canada steal market share and fragment liquidity.



Fig.3

In the US, where these changes to market structures originated, 35 per cent of trading liquidity resides in alternative trading venues. Meanwhile figures from the TABB Group revealed that the market share at the major US Exchanges (The NYSE proper and Nasdaq) changed from 38 per cent and 37 per cent respectively in January 2007, to 20 per cent and 30 per cent in March 2009.

In Asia the picture is slightly different with the Tokyo Stock Exchange still the dominant player although MTFs, such as SBI Japannext and Chi-X Delta, are springing up prompting the Tokyo Stock Exchange to introduce its faster, more scalable Arrowhead platform as it wrestles with the concept of competition for the first time.

The net effect of all this fragmentation is that tick sizes are reduced, bid-ask spreads narrowed and transaction costs increased. But liquidity fragmentation is only part of the picture. A global increase in electronic trading and a rise in the use of algos has created the perfect breeding ground for High Frequency Trading (HFT) shops to enter the fray. This makes it even harder for traders to get their order done without impacting the price they want to trade at or the amount they need to take. According to TABB Group (Fig 2) HFT now accounts for over a third of all European equities volume. If you drill down to UK equity lit and dark electronic order books you are faced with the startling statistic that HFT accounts for 77 per cent of equity turnover leaving only 23 per cent of natural order flow to aim for.

The combination of HFT, fragmentation of liquidity across multiple trading venues, dark pools, global bank crossing networks, lack of transparency and persistently low volumes means that traders need a keener understanding of the ebb and flow of liquidity to decide where best to trade. So as market structures continue to alter the exchange traded equities landscape through upcoming MiFID 2 regulation, it is getting harder for traders to be able to view meaningful liquidity across multiple trading venues in one place. They need sophisticated tools to help them make smarter trading decisions and save money by hitting the price and amounts they need with minimal market impact.

In 2011, Thomson Reuters is committed to delivering a suite of new transaction capabilities on Eikon, its next generation desktop, across the full trading workflow, to help equity and derivatives sales traders and traders across the buy and sell side - cash equity desks, hedge funds, pension funds, prime brokers and retail brokers, save their costs, boost profits and grow their business.

Traders need access to breaking news and sophisticated analytical tools, smarter price discovery tools, connectivity to multiple trading venues and markets, tools to rank their broker and tools to measure their transaction cost analytics and to be part of a global community, all at low cost so they can concentrate on what they are good at.

Sales traders and traders across the world face ever increasing competition and challenges, whether it is fragmented markets, understanding the implications of new regulation, pressure on commissions, low volumes and high volatility or how to connect to hot, emerging markets. Smarter trading tools at the heart of the workflow on the desktop with direct connectivity to global pools of liquidity are a must if they are to thrive in this new era.

In 2011, markets will continue to fragment and traders will need to look beyond primary exchanges and lit order books to find liquidity. A mix of trading strategies is essential and with an increasing regulatory reporting burden coming, traders will need to be ahead of the curve. However, if you understand the market structure you can, find the opportunities.

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