MiFID II: Electronification of Trading
This blog from Ralph Achkar was originally entitled “MiFID II – Will Electronification Accelerate New Trading Opportunities?” and posted on the Tabb Forum.
The electronification of trading in asset classes outside of equities is not a trend brought about only by MiFID II. It’s been slowly and inexorably creeping towards becoming a reality for a number of years and MiFID II has served only to hasten its realization. The debate about what instruments are to be exchange traded and what to do with them bubbles away relentlessly, as does the notion that the HFT floodgates will open to more asset classes and the resulting deluge will change the financial system as we know it.
However, for this piece I’d like to take a look at what a potential market structure might look like rather than the detail of what the regulation might mean – a 10,000-foot view, if you will. Under MiFID II, electronification will, in short, on a macro level, mean two things: first, the market will see a change in trading models – e.g., quote and order driven – and second, it will need new venues – e.g., OTFs – to trade in. Such changes also have implications on existing and new participants and the value they bring to the table – e.g., dealer pricing and market makers.
Market structure, but not as we know it
Existing venues use trading models designed to cope with a specific asset class using a defined trading model, rather than with a certain capacity in mind. Thus new trading models and new trading venues would need new infrastructure and would potentially open new deployment models. For existing venues to expand their capacity will be expensive so there is clear potential for new entrants to take up the slack with smarter ideas. A good example is MiFID II’s new OTF model, drawing parallels with how MiFID I enabled MTFs across European markets. These new OTFs still have to set up infrastructure capable of handling any potential new trading models and new capacity demands. As such, they will be hamstrung by the same economic constraints that MTFs were.
One of the differences between the landscapes that the two regulations occupy is the maturity of cloud technology and it’s this that could provide a way forward. Compared to 2007, cloud technology is more evolved, and the regulatory environment around it is a bit clearer. Some of the capital markets infrastructure is already cloud-based, and more will be moved there. It’s no longer a question of whether to move to the cloud, but rather one of how to.
This gradual shift of existing technology into the cloud reminds me of the late-nineties internet boom. At that time, established businesses acted slowly, seeing the web as purely a shop window with little use outside of marketing. These companies slowly became more enlightened and realized that the internet was much more than that. It gave them the ability to expand internationally, source better suppliers, reach new customers and grow like never before. However by the time they had realised that they needed to move online, they had been replaced by companies born online.
Where the venues lead…
MiFID II might inadvertently have accelerated a set of circumstances that could place the cloud at the heart of the capital markets. Existing bricks and mortar trading venues will try to move to the cloud – greater flexibility in terms of both capacity and infrastructure, and a greatly reduced cost base – but new venues, including OTFs, may well decide that being based wholly in the cloud is much more sensible. Why move to the cloud when you can be born there? Especially when new ideas do not suffer from shifting costs constraints.
Once these venues adopt a cloud deployment model, the very reason for a physical presence close to that venue becomes redundant. Trading firms will no longer have to have offices next to the exchange. Latency dynamics will change and the technology race might take new directions. Participants will need to look at advantages for a cloud model rather than just a latency race to zero. Instead of a Geneva-based firm locating its platform in the same datacentre as the exchange in London, they will simply connect to a cloud or multiple clouds with the smartest connection models they can find at that time; internet, point to point or ecosystem approach.
This change in infrastructure needs and decrease in footprint will lower barriers to entry and will precipitate the growth of smaller, more nimble trading firms. Potentially this will attract more liquidity into markets from existing or new participants across asset classes. Thus, in this new virtual market, smarter, flexible connectivity will be at the heart of the race. Not just who has the fastest, highest capacity connection, but who has the smartest flexible connection into as many destinations as required. The ability to define what capacity and speed you need, and how quickly you need them, will be critical.
And where will the current exchanges be in all of this? Well, if MiFID I is anything to go by, they will adapt. While they may not be as agile as the cloud-only venues, they will find new ways to maintain their market position. After all, the physical infrastructure built up over the past few decades is not easily undone and it will be some time before new venues have enough flow to compete with centuries-old institutions.
Like the internet example given above, we need to consider the end state rather than be tempted to focus on the immediate transitional phase.