LIQUIDITY FRAGMENTATION ON LIT MARKETS |
Posted: July 22, 2021 |
In a recent note, we discussed how a substantial number of transactions conducted outside of the visible order book can increase volatility and negatively affect retail transaction costs through spreads and liquidity. In this case, an important aspect of increased liquidity is how it becomes fragmented due to increased competition between trading venues - or perhaps not. It is broadly undisputed that more competition among operators of trading venues has been to the benefit of investors in that it has reduced transaction costs. Critics argue, however, that the proliferation of trading venues – as a result of regulation – had a detrimental effect. According to this view, the European Financial Instruments Market Directive (MiFID), the US National Market System Regulations (RegNMS) and comparable regulators in other jurisdictions have fuelled the emergence of arbitrageurs: adverse selection effects on liquidity provision and, therefore, price formation clearly outweighs the benefits of reduced transaction costs. In other words, the changes to the market structure as it existed until 2005 – 2007, aiming at increasing competition among trading venues did in fact distort competition since it caused a fragmentation of the trading interest which had hitherto been concentrated at a limited number of primary exchanges; plus, it incentivised the formation of high frequency traders that, in an opportunistic manner, exploit unsynchronised information between venues. It is certainly the case that the share of high frequency trading (HFT) has increased considerably in the last decade and is now estimated to account for some 30% to 40% of European stock trading. However, for a variety of reasons, it would be disingenuous in the context of causality to simply blame the number of venues for observable HFT or market model imbalance. Firstly, this notion implies that the concentration of liquidity on a limited number of traditional exchanges had been beneficial to global liquidity. The volume of over-the-counter trading long before the appearance of the new trading venues invalidates the above point of view. The decrease in local liquidity (to use this term for the shrinking trading turnovers at traditional exchanges) would have had to be overcompensated by additional regulatory trading obligations for broad ranges of instruments, by a much more active retail trading community and by a number of other factors. It should be noted, by the way, that the advocates of a restoration of the old market structure deliberately keep quiet about the fact that it had been the primary exchanges, long trying to ignore the new competition, which opened-up their platforms to HFT in the first place (meanwhile even appearing as buyers of HFT operators). The most inconsistent aspect to the reproach of a regulatory-driven fragmentation of venues and, with it, liquidity, is that today’s trading venue landscape is extremely heterogeneous. That is worth looking at in detail. As we mentioned above, recent regulation has broadened the scope of subject to trading obligations and has introduced different types of venues for various classes of instruments. However, this greater heterogeneity has had no adverse effect on liquidity. The reason for this is simply because the new venues (such as Multilateral Trading Facilities, MTFs) that are accused of diverting liquidity from traditional exchanges are lit markets. On transparent trading venues, the increased competition and the overall results of regulation also had effects on the suppliers of liquidity. On the one hand, for those providers that had previously provided substantial volumes of liquidity, the provision of liquidity has become an unattractive business model: Basel rules on equity deter banks from their own trading business. Their place had been taken by ‘real’ liquidity providers the business model of which involves taking losses for the sake of providing liquidity, offset by the bid/ ask spread. The intensification of competition between them has led to a reduction in their real interest rate spreads, which in turn clearly has a positive impact on global liquidity. Dark trading, on the contrary, does indeed have negative effects on liquidity. The price of shares traded in the dark is based on other transparent, pre and post-trade place references (ironically, this largely includes primary exchanges). If you accept liquidity as the ultimate measure for the informative value of the reference price of a given asset it is not so difficult to imagine the impact dark trading has because it doesn’t contribute to the depth of the lit market order book. The changing structure of the market cannot be summarized under the negative term "fragmentation". Rather, it is appropriate to describe the process as "specialization", since technological advancement and changing consumer demands are inevitable due to the ongoing development of legislation ( which has been repeatedly witnessed in other industries).
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