MTFs look to new markets for growth

Expansion so far has been at the expense of fee revenue

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On the face of it Europe’s new exchanges had a pretty good year in 2009. Aggressive fee cuts helped these new trading venues, known as multilateral trading facilities, take business from traditional exchanges, which all lost market share.

However, following early success some in the business are now pondering what MTF 2.0 might look like, as they fight to prove to shareholders that they can translate gains in market share into profits.

A year ago Europe’s four main entrants – Chi-X Europe, Bats Europe, Turquoise and Nasdaq OMX Europe – shared 14 percent of the European market, according to data from Thomson Reuters. In January, they had more than 20 percent.

Their growth was partly down to a price war instigated by the various platforms as they sought to undercut the incumbent exchanges with lower tariffs.

The strategy paid off in pure market share terms but the cuts meant the firms’ modest revenues were under pressure and by the end of the year questions were being asked about their commercial viability. These concerns were realised late in December when Turquoise, the most high-profile of the MTFs, agreed to sell up to its main exchange rival, the London Stock Exchange.

Turquoise’s market share may have fluctuated last year but it was the top-performing MTF after Chi-X Europe until it was overtaken by Bats Europe in November, according to Thomson Reuters.

The withdrawal of Turquoise, despite its decent market share, has focused attention on these platforms and their plans to move into sustained profitability.

Only Chi-X Europe, which has averaged a European market share of 13.5 percent over the past three months, can lay any serious claim to having broken even.

MTF sources said the break-even point, depending on overheads, is estimated to be about 14 percent market share.

Geographic expansion is an option and one that Nasdaq OMX Europe is pursuing. Its chief executive Charlotte Crosswell said last week the system would offer eastern European equities as soon as the necessary changes are made at clearing houses. However, regional expansion is complicated.

Of the four main MTFs, only Turquoise is not part of a larger, international group – at least until the LSE deal goes through, subject to an Office of Fair Trading inquiry.

Chi-X Europe is twinned with Chi-X Global, which has interests in Canada and Australia among other markets. Bats Europe is part of the highly successful US franchise Bats Exchange and Nasdaq OMX Europe is owned by the transatlantic exchange giant.

Furthermore, expansion outside Europe is risky given the absence of regulation equivalent to the November 2007 Mifid trading reforms that allowed the MTFs’ proliferation in Europe. Diversification by product is another alternative, according to exchange professionals.

The US equity market, where the Bats Exchange plans to launch before the end of this quarter its first equity derivatives trading platform, may offer a precedent.

But new asset classes pose a different set of challenges to those the MTFs faced when they were setting up in the relatively standardised European cash equities market.

Herbie Skeete, the managing director of specialist trading consultancy Mondo Visione, believes new products represent “an opportunity and a risk for the MTFs”.

He said: “There is potential for them to expand into other asset classes but they need to do this with their eyes open. For them to be successful in new products, such as derivatives, they are going to invest heavily in research, product development and marketing – functions they have not focused on historically.”

The MTFs have been successful in equities largely because they have been able to undercut the exchanges by charging fees in line with their relatively low overheads.

However, derivatives on those equities are traded in a different way and the relative lack of standardisation places the onus on the trading venue to develop and market these contracts, which requires up-front investment the MTFs did not need to break into cash equities.

Skeete said: “The MTFs have grown up keeping their costs to a minimum but to move into new asset classes they must invest in a range of products knowing not all of them will be a success. They will have to take on additional staff and their costs will inevitably rise.”

Constantinos Antoniades, a former Goldman Sachs bond trader who has launched Vega-Chi, the first convertible bond MTF, said: “In equities there are relatively simple and low-cost off-the-shelf solutions whereas in more specialised products, such as convertible bonds, we had to use our knowledge of the market and work together with our clients to develop the specific solutions that suit their requirements.

“This applied to everything from technology to the post-trade services structure. These are some of the issues that MTFs need to face when entering new asset classes.”

Vega-Chi is outsourcing the clearing and settlement function to BNP Paribas Securities Services, the custody arm of the French bank that has built the post-trade infrastructure for the fledgling bond platform.

The lack of post-trade standardisation in non-cash equity asset classes is the main barrier to product diversification for Bats Europe, according to its chief executive Mark Hemsley.

He said: “We have thought about other asset classes among other things, but the truth is the US market is very different to Europe. In the US there is a single established clearing mechanism and the contracts are fungible but this is simply not the case in Europe.

“Our platform is well suited to options trading but we’d need to see a clear path towards a resolution of the clearing issue for European equity options before we would start to consider seriously expanding into this asset class.”

Another challenge, according to Antoniades, is to understand the commercial dynamics at play between the buyside and the brokers, which are often different to those in share trading.

He said: “Outside equities, MTFs have to be more specific about their target client base, without of course being discriminatory. You will find that sometimes the interests of the buyside and the sellside operating on an MTF could be in conflict given that sellside firms also often operate closed and opaque crossing networks relating to such asset classes without any pre-trade or post-trade price transparency.

“Also, will the benefits of better pricing be passed to the end-clients or will the MTF be used as a tool for broker-dealers to enjoy higher margins with little of the benefit being passed to the end-clients?”

Bats Europe and Nasdaq OMX Europe said they were watching the market for signs of demand for new asset classes but planned to stick with equities for the foreseeable future. Chi-X Europe and Turquoise declined to comment.

The challenges of expanding into new asset classes are great but it is likely only to be a matter of time before one of the MTFs seeks to appease frustrated shareholders by moving into newer, higher margin markets.