Europe’s Fragmented Liquidity Challenge

Buy-and sell-side are now turning to auctions and systematic internalizers.

Fragmented liquidity in the UK and European equity markets has posed a challenge for the buy and sell sides for many years, but the migration of volume away from lit markets to systematic internalizers and auctions has gained attention from market structure data experts. 

In December, Liquidnet held a webinar examining the liquidity landscape in 2023 and what’s ahead for 2024. “The real pain point coming out of this is primary lit markets, excluding auctions, remain at historic low levels, averaging 32% of overall volumes, down from 41% back in 2021,” said Gareth Exton, Head of Execution and Quantitative Services EMEA at Liquidnet. 

However, while volumes on lit order books fell below historical averages, systematic internalizers’ (SIs) wallet share continued to grow, averaging 25% of on-exchange volumes in Q4, up from 13% in Q1 2021, said Exton on the webinar. 

Despite efforts by regulators to curtail trading in the dark, Exton said that dark trading has remained steady at about 8% to 10% of the total market value, while Large-in-Scale (LIS) has become a consistent 35% of the market, referring to a category under MiFID that qualifies for a pre-trade transparency waiver. 

“We’re seeing MiFID II push the market to take a more holistic approach and consider more liquidity sources to achieve best execution. It’s driving liquidity fragmentation and creating a more difficult liquidity landscape. But technology is available to interact with all liquidity in the markets, meaning that no one is missing out from a best execution standpoint,” said Dan Enstedt, Head of Business Development EMEA at FlexTrade. 

This is also happening in a post-Brexit world, where multilateral trading systems (MTFs) operators had to create separate platforms under UK and EU laws. “Brexit has doubled the number of MTFs with separate legislation vs. EU legislation,” said Robin Mess, co-founder and CEO of big xyt which aggregates liquidity across all exchanges, MTFs and off-board venues in the region, filtering out the non-addressable trades. 

In January, using big xyt’s data, Best Execution reported that 2023 saw a severe drop in intraday trading in the lit continuous trading in the order book -excluding dark pool and auction activity, reaching a new low of 37% of the overall market, which marked a drop of 12% since the MiFID II implementation in 2016.  

According big xyt’s data analysis, lit/order books accounted for about 57.90% of total volume traded in the UK and European equities, while lit/auction closing had 22.35% of the volume, followed by dark with 11.31% and periodic auctions with 5.71%.  Meanwhile, the lit/auction opening had slightly less than one percent. In addition, Aquis and Cboe have both introduced alternative closing mechanisms (ACMs), which have garnered 1.69%, challenging the primary exchanges. 

Fragmentation & MiFiD II 

On a Bloomberg Intelligence webinar in October, 36% of traders cited liquidity fragmentation as the biggest issue facing them in order execution. About 24% of traders believe a consolidated tape will make it easier to get their orders executed. This was based on BI’s annual proprietary UK and European equities trading study which surveyed 87 fund managers.  

Among the reasons for liquidity concerns in EMEA is that ticket sizes are often 50% of average daily volume, said Nicholas Phillips, market structure analyst. Phillips noted there are too many venues in Europe making it difficult to find liquidity.  

For example, a stock like Vodafone is traded not only in London, its listing venue, but across other primary exchanges, MTFs and dark venues, he said.  

Speaking in December, Larry Tabb, head of market structure research at Bloomberg Intelligence, said he was surprised by how much volume had moved off the lit exchanges. “Right now, roughly 65% of this flow has migrated off-exchange, and 35% is on order books,” he said.  

Though there’s been a relaxation of the double volume caps in the UK, the flow has not gone to dark pools, said Tabb. “It’s actually being executed through systematic internalizers, and traditional exchange mechanisms as well as auctions,” said Tabb. “Auctions have gone up to about 25% of the flow within Europe,” he said.  

“The migration away from intraday, continuous markets is occurring because of the growth in passive flows and because of the movement towards ETFs, and the difficulty in finding any type of sizeable liquidity in the market, so flows are just moving towards the end of day auctions,” said Tabb.  

Switching Channels 

Mark Montgomery, Head of Strategy and Business Development at big xyt , said: “Lit continuous markets have pushed volume to other channels – including periodic auctions and a category known as sub-dark block activity for below Large-in-Scale (LIS) orders which have the ability to trade at the midpoint in the same time window.”  

Periodic auctions are now about 5% to 6% from zero in 2018, estimates Montgomery. “It’s been stable growth since the middle of 2021, when it had 3% to 4% market share, and it’s picked up since then,” he said.   

Several exchanges and MTFs, such as Cboe Global Markets and Turquoise, owned by London Stock Exchange, Group, have launched periodic auctions, which match trades several times a second.   

“This allows firms to enter orders in line with the lit order books,” said Montgomery.  “It’s a way for either the bank or algo provider or the ultimate buy-side firm to have lower transaction costs,” he said.  

The question is whether the shift in market share between the lit continuous markets vs. the SIs and the auctions should worry the marketplace?   

Accessing All Venues  

Michael Green, Managing Director, COO of EMEA Electronic Trading at BMO Capital Markets, confirmed what many in the market know to be the case. “Evolution has been constant in the European and UK equity trading equity markets for 25 years now. It is a reality, and there is no reason to worry.”   

Green said BMO is agnostic to the venues it trades on and focuses on providing access to all venues and trying them out. “We determine venue selection by evaluating the venue’s performance for our clients.”   

BMO Capital Markets launched its global algorithmic trading suite for European markets in May of 2022 – two years after its acquisition of the Clearpool Group. Clearpool’s algorithmic management system, which previously serviced North American equity markets, has been further developed to incorporate the market and micro-structure across the European landscape.    

Citing the flexibility of its AMS platform as an advantage in accessing liquidity, Green said the team enhances the algos to optimize performance across venues. Members of his team specialize in the micro-market structure in the US, Canada, and across the European markets.   

 Currently in Europe, the AMS is using 85 different execution services, encompassing lit venues, dark venues, MTFs, periodic auctions, conditional venues, and systematic internalizers (SIs).   

“We have a performance-based mindset. We experiment, we iterate, we optimize. We talk to our clients about how we are accessing markets, including how we are accessing SIs that they encourage us to access,” said Green.  

Alternative Liquidity Providers 

With the increased fragmentation across European markets, Andy Mahoney, Managing Director of FlexTrade EMEA, said he has seen a higher demand for alternative sources of liquidity such as electronic liquidity providers and SIs which the execution management system has integrated.  

While the SIs were introduced under MiFID I, banks had their own crossing networks for matching orders on behalf of their clients. When MiFID II halted private crossing networks run by banks, requiring them to reregister these services as SIs that can only execute bilaterally against their own book, that is when SIs grew their volumes. 

Pointing to changes in lit markets and the fact that less volume is being executed on traditional stock exchanges, Mahoney said he predicts that “more decisions are being taken to execute on alternative trading venues, firstly by the sell side and potentially this year and next year by the buy side themselves,” said Mahoney.  

Mahoney said there’s also a responsibility on the buy side to understand how liquidity from SIs is presented and there’s a demand on the technology provider to take in all the quotes and aggregate them. “Technology is no longer a barrier,” said Mahoney, noting that FlexTrade’s EMS has capacity to consume the volumes of SI quotes.  

In the past, SIs didn’t have the technology to interact with the buy side, now they have that capacity, said FlexTrade’s Enstedt. In addition, Enstedt said the FIX protocol has allowed the buy side to see if brokers have executed their orders on SIs. For example, tag 30 is a FIX message protocol field that contains data about the venue on which an equity trade is executed.  

 If the buy side were to route flow to a broker, “they could realize that even though they’re not connecting to an SI directly, that 25% -30% of their fills are being traded on an SI,” said Enstedt. In this scenario, the buy side might question: “why would I not interact with those SIs directly?” asked Enstedt.  

Many of the SIs are actively going after the buy-side directly, but the brokers are also accessing the SIs on behalf of their clients.  “Some of our strongest partnerships with the buy side are the ones where we provide access to the SIs,” said Green. BMO is building unique algo solutions to allow buy-side clients that don’t necessarily have the technology to go directly to the SI, he said. 

Internal Crossing 

With brokers looking to manage their costs, Rajiv Shah, Head of OMS Sales in FlexTrade EMEA, notes that “brokers are asking about connectivity to electronic market-makers through the OMS as well as other innovations such as OptimX Markets,” referring to the new block trading mechanism planning to go live in the US and Europe.   

Outsourced trading desks which service the buy side though FlexTrade’s OMS, are seeking connectivity to the same venues, “which is part of a cost-play,” said Shah. In addition, brokers are internalizing some of this flow by crossing trades within the OMS.   

“An advantage that the sell-side has is that if the order cannot be crossed off-exchange and it needs to be crossed on exchange, then the system will automatically send out the individual legs to the exchanges,” said Shah.  

Assembling Blocks 

Meanwhile, a significant percentage of large block equities trading in Europe is bilateral against a bank or broker’s balance sheet, and exchanges are looking to enter this market. 

In August, Aquis Exchange PLC announced it acquired a stake in OptimX Markets, a US based startup focused on assembling block trades, reported Markets Media.  Aquis said it will work closely with OptimX in the UK and Europe on adding additional connectivity between its “successful dark pool (the Aquis Matching Pool) and providing clients with the ability to cross large blocks.”  

Peter McStay, Head of OptimX Europe, said the startup is approaching the market as a neutral technology solution for the sell side to find the parent order proposition through integration with buy-side workflow. 

BMO’s Green said OptimX is an innovative new block execution offering that it is looking forward to supporting at launch. “OptimX is recognizing that a lot of the underlying liquidity that is entered in other block pools comes from a number of different brokers on the market,” said Green. OptimX is therefore looking to make sure that the underlying brokers are rewarded.” 

In addition to supporting the launch, he noted that BMO Capital Markets is partnering with select brokers using the AMS to allow them to access OptimX.  

For example, in November, The Trade reported that UK-based Liberum has a new relationship with BMO Capital Markets’ Clearpool – in which Liberum’s new A-PEX algorithm will connect to Clearpool’s AMS – which will allow the business to more easily smart order route, with extra configuration abilities, to OptimX.  

Looking Ahead 

As 2024 plays out, some market participants have called for progress on a consolidated tape in both the UK and the EU to address the fragmentation in Europe ‘s securities by creating more transparency and competition between venues.  

“Traders believe that a consolidated tape is key to improving the liquidity and fragmentation issues that the buy side is facing,” said Nicholas Philips, BI’s market structure analyst on the webinar.  

In January, the European Parliament voted to adopt revisions to the MiFIR and MiFID regulations, which involve the creation of centralized data feeds from the various execution venues and trading venues, reported FundsTech.  While the first tape slated to go live in 2025 will be for bonds, tapes for equities and derivatives are scheduled to be operational in 2026.  The UK Financial Conduct Authority is moving forward with its own plans for a consolidated tape for UK equities, but it plans to introduce a bond tape first. 

“The focus seems to be on the lit, continuous markets and SIs,” said Liquidnet’s Exton. “That is what is driving regulators at the moment with the UK Wholesale Markets Review and the MiFID/MiFIR Review,” he said. Regulators keep talking about the consolidated tape and changes to the SI rules, but nothing has happened yet. A stream of consultation papers is expected to come out in 2024.  

In the meantime, market participants are keeping an eye on the various venues and market mechanisms as they continue to evolve across the UK and European equities landscape.