James Baugh, head of EMEA equities market structure at Citigroup
What is your view on the way in which market structures have changed since the introduction of MiFID II?
James Baugh: MiFID II has been fairly broad in terms of its impact on the European equity markets despite the sell-side already having to manage for MiFID I, especially when you consider some of the obligations that are now bestowed upon the buy-side, such as unbundling, meeting transparency and best execution requirements.
In regards to execution, the wider market impact has been on the liquidity landscape which has seen further fragmentation, adding additional complexity to the workflow. This isn’t just about connecting to every new liquidity destination but more about understanding the impact on the parent block when interacting with certain types of flow and also in knowing the client’s benchmark to know how best to work that business in what is a very different liquidity environment.
Here we look at two things. One is in regards to what we would describe as liquidity sourcing, understanding where we access liquidity to find best outcomes for our clients. The way in which that has evolved has really been more to do with how we outsource liquidity, that perhaps firms like ourselves matched using broker crossing networks pre-MiFID II. Now that we can no longer systematically match client-to-client business, we have to think about how we get that business done. There are three sub-themes that we consider and those include the rise of periodic auctions, the growth in liquidity providers – those market makers that are registered as systematic internalisers (SIs) – and also the continued growth in electronic block trading and the wider use of conditional orders.
The other aspect that we look at is liquidity provisioning: how to provide clients with efficient access to our house inventory while facilitating access to our systematic internaliser as a way to optimise the amount of business we can internalise to manage market impact and execution costs, albeit client-to- house, rather than client-to-client, as it was pre-MiFID II.
What we are also starting to see is a consolidation of flow to fewer, larger brokers and that has been driven, in part, by some of those obligations on the buy-side, meaning that they need to simplify their own workflows so that they can better monitor and manage best execution.
How do you view the emergence of new trading venues, such as periodic auctions and systematic internalisers (SIs)? How will that pan out in future?
JB: First and foremost, we have to appreciate that the channel shift in liquidity has been relatively muted so far; we are only talking about a couple of percentage points in terms of the overall share of market. It’s likely that the trend will continue, however, the question I how far can it go? If we think about what is a relatively fluid regulatory environment right now, it’s difficult to think too far ahead as to what might or might not happen.
But if we take the liquidity providers (LPs) and the market makers, it’s worth also appreciating that these firms were already price makers in broker crossing networks (BCN) pre-MiFID II and therefore what we are seeing here is a reverse of that flow, perhaps in a much more positive way where the buy-side has greater transparency of who they are interacting with.
So, when we talk about the rapid rise of the LP SIs, I would caution against some of the regulatory scrutiny, knowing that pre-MIFID II these firms were already doing a significant amount of business within the BCNs.
Have there been any unexpected developments or changes to market structure since the introduction of MiFID II?
JB: There has been a lot of discussion around some of the unintended consequences of MiFID II, particularly considering that the key regulatory objective was transparency and to encourage more on-book activity and encourage business to migrate back to primary markets. In many respects, this aim is the opposite of MiFID I, which focused more on encouraging competition in where you can transact business by removing the concentration rule.
Unfortunately, when we think about best outcomes for the end investor and knowing the diverse nature of the business that we have to manage, putting business on a lit exchange is not necessarily going to achieve those goals. That’s why we’ve seen the market develop and evolve alternative mechanisms for getting business done, albeit within the confines of the current regulatory framework.
When we think about periodic auctions and LP SIs, it was relatively telegraphed ahead of MiFID II that we would start to see alternative liquidity opportunities arising to provide different methods of executing client business, so there shouldn’t really have been any major surprises here. That said, with the primary markets maintaining, but not growing, their share of market, a key objective of the regulator has not been met, which explains, despite the modest shift in liquidity, the ongoing regulatory scrutiny.
The use of periodic auctions was really initially established as more of a hedge to the double volume cap regime on dark trading. However, it has become quite a useful way in which brokers can outsource some of that BCN liquidity, providing natural client matching opportunities, which they had previously internalised. Now, where we have to outsource that business, one way to do that is to execute in a periodic auction, where because of the timing mechanisms, and in part because of the ability to utilise broker preferencing logic, you have the chance to match that client-to-client natural liquidity. And when we look at the performance, the periodic auctions are providing a useful platform to do that business.
Have there been any other drivers impacting on EMEA market structures since the introduction of MiFID II?
JB: Whether we like it or not, a lot of the changes around us in respect to market structure and innovation have really been driven by regulation. What is quite useful for us is that our end clients are certainly much more focused on broker performance and best execution, in part because the landscape has become even more fragmented and complex.
On top of that, when you consider the obligations that are now bestowed upon the buy-side, it really does mean that the sell-side have to sharpen their focus to make sure they are providing that level of service, that degree of transparency to enable the buy-side themselves to provide the end investor with the best service they can.
Looking ahead Brexit remains the great unknown but depending on the direction of travel there will clearly be impacts on market structure beyond MiFID II. Already we have to consider impacts of the Share Trading Obligation on liquidity dynamics in a post Brexit scenario.
How is Citi addressing changing buy-side requirements as market structure complexity increases?
JB: We are making strategic investments and building resources to help our clients navigate the market complexity, particularly in respect to our Execution Advisory Service, where we have a dedicated team focused on optimising trading performance. This is a crucial area to help our clients optimise the performance and outcomes based on the benchmarks that clients are looking to achieve.
The other area of focus is around rebuilding and recalibrating our algo offering to take advantage of those new liquidity opportunities, whether it is adding new conditional venues to get more electronic block business done or whether it is ways in which we measure and review the available LP liquidity for some of the more aggressive, cross-spread type liquidity where investors are happy to interact with that type of flow.
How do you see the relationship between the buy- and sell-side evolving from its current state?
JB: The buy-side and sell-side are getting closer, particularly as our clients look for more innovation around liquidity access. When you think about the pace of this change, I would look back to MiFID I with the fragmentation of liquidity and the proliferation of BCNs. That didn’t really happen in the first year; it took a good period of time to develop and I think that’s probably what we are seeing here.
At Citi we are taking a number of steps to adapt our platform and offering as the market structure evolves. One area of focus is on how we provide access to our house inventory to meet client liquidity needs. But more so, how do we do that in an efficient way through the electronic channel in addition to the more traditional high-touch DCA block or IOI routes.
The evolution here is more about understanding the needs of the client. When you think about the diverse nature of the flow that we receive, you have to look at a quant fund very differently versus an institutional client, in terms of the types of liquidity they want to interact with and how we make sure that we are providing access to that type of liquidity. This will season and develop over time, and that’s where coming together with your underlying clients and understanding their needs is very important. This isn’t a one-size-fits-all opportunity and will be a slower burn, in terms of how banks and SIs, like Citi, will look to differentiate over time.
How will the role of the broker develop in future as the market structure continues to evolve?
JB: Given the increasing complexity, the role of the broker will become, more relevant and important in helping the buyside to source liquidity. We are very proactive in terms of how we are looking to develop our business and allocate resources to take advantage of structural changes as a way to differentiate ourselves in a market that has become fairly commoditised.
What needs to play out is that consolidation of liquidity; it is something that is well-discussed, but actually we haven’t necessarily seen some of those brokers as negatively impacted as some might have you believe. But we are definitely seeing a consolidation of flow driven by the underlying client being able to declutter and manage what is a very different set of regulatory obligations.
What have been the positive changes brought about by regulatory change?
JB: One of the key objectives of regulatory change was to encourage greater transparency and there has been a benefit from the new reporting regime and that has been useful in driving some conversations in other products, like exchange traded funds (ETFs).
The other key positive development here is the buy-side and sell-side coming together, the buy-side becoming much more focused on broker performance and meeting their best execution obligations. That is encouraging the sell-side to sharpen their focus and make sure they are providing best outcomes, access to unique liquidity and that they are able to work together on optimising trading performance. That can only be to the benefit of the end investor.
On the buy-side the unbundling of research and execution payments has been positive in terms of allowing the heads of dealing on the buy-side desk to concentrate more on best execution, rather than having to cut cheques.
There are, however, still many challenges left. The concern is that the market has become more fragmented and complex, and invariably, with that costs increase, which is always going to be an issue when trying to provide an efficient service to the end investor. I sometimes think that gets overlooked by the regulator.
How do you view any further regulatory change or amendments to MiFID II playing out?
JB: We don’t anticipate a massive sea change in the near future, but there are some fairly significant developments that we may see and have to be ready for. One is the impact of the public tick regime on both lit venues, more specifically periodic auctions, and on SIs. As we understand it, towards the end of this year or early next year, SIs are going to have to adhere to the public tick regime in all sizes, which means SIs will be significantly limited in their ability to price improve unless that business is above large-in-scale LIS.
Similarly, if you are no longer able to match mid-price in periodic auctions, and given the majority of business is done below LIS using peg-to-mid-order-types, we have to start thinking about the impact this might have on the liquidity landscape and how to get that type of business executed.
The frustration for the market is that this is not just focusing on mid-price or price improvement per se, this is more about being able to match intra-tick where there are an odd number of ticks in the spread, so you can still match at mid-price but only if there is an even number in the spread. It does seem a little bit nonsensical trying to implement these sorts of changes that could have a fairly significant impact in being able to trade at fair value.
Thinking about the SIs, we think the LPs may suffer if they are not able to offer price improvement unless they evolve their models. For bank SIs it is slightly different because price improvement itself is not the determining factor in terms of how we get business done, but it is going to lead to certain changes to the liquidity dynamics that we need to cater for. That is something we need to think about in the relatively near term.
The other area of interest is around the market-on-close business, where we have seen liquidity very much concentrated on the close. The numbers will tell you that some of the more liquid names, not just on LSE but on other primary markets, see 30%-35% of the daily volume traded on the close. We are now engaged with a number of alternative platforms which are looking at ways in which they can provide solutions or ways to get that market-on-close business done away from the primary.
Again, this could see some structural changes in the relatively short term. However, as an industry we need to be thoughtful about how we approach this, because what you invariably end up doing here is diluting the actual reference price itself. It’s also worth noting that a number of institutions are also looking at benchmarking away from the close which in in itself is an interesting move and one to watch.