The structure and quality of equity trading and settlement after MiFID

Trends in the European Securities Industry Milan, January 24, 2011 The structure and quality of equity trading and settlement after MiFID Prof. Dr. Peter Gomber Chair of Business Administration, especially e-finance E-Finance Lab Goethe-University of Frankfurt

The structure and quality of equity trading and settlement after MiFID 1 The new landscape in Europe 2 Trading Dataset and research model 3 Trading Results of the economic analysis 4 Post-trading Initiatives analysis 2

Regulatory approaches and evolution of technical platforms in European equity markets Collateral Central Bank Management Link Up Markets TARGET2-Securities 1 st Giovannini Report Single Settlement Engine / Euroclear Settlement for Euronext-zone Securities Financial Services Action Plan (FSAP) MiFID New MTFs Code of Conduct MiFID II 1999 2001 2003 2005 2007 2009 2011 2013 2000 2002 2004 2006 2008 2010 2012 Appointment of the Committee of Wise Men 2 nd Giovannini Report European Commission gathers positions of market participants for MiFID Technical platforms Regulatory Approaches Important Milestones 3

Integrity, transparency and competition among trading systems are key goals of MiFID The European Commission has presented a proposal for a new Directive on investment services and regulated markets. [ ] It seeks to establish, for the first time, a comprehensive regulatory framework governing the organised execution of investor transactions by exchanges, other trading systems and investment firms. Once adopted, the proposed Directive will uphold the integrity and transparency of EU markets and foster competition between traditional exchanges and other trading systems, with the effect of encouraging innovation, reducing trading costs and releasing more funds for investment, ultimately boosting economic growth. EU Commission: Investment services: proposed new Directive would protect investors and help investment firms operate EU-wide, 19.11.2002 http://europa.eu/rapid/pressreleasesaction.do?reference=ip/02/1706&format=html&aged=0&language=en&guilanguage=de 4

Motivation for the economic impact analysis of MiFID Competition for order flow is a phenomenon in equity markets on both sides of the Atlantic ECNs versus NYSE / NASDAQ in the U.S. Chi-X, Turquoise and BATS versus incumbent exchanges in Europe Potential effects of competition Positive New services and innovations Stimulate the design of new trading platforms Reduction of explicit trading fees Negative Fragmentation of order flow potentially may lead to a reduction of market liquidity, rising implicit trading costs for investors and thereby cost of capital for issuers (Amihud & Mendelson 1986, 2000) What is the effect of MiFID-induced competition for order flow on market liquidity and thereby on cost of capital? 5

Related literature regarding inter-market competition Theoretical models Hendershott and Mendelson 2000 Parlour and Seppi 2003 Degryse et al. 2009 Different modeling approaches, similar conclusion: Competition has ambiguous welfare effects Empirical studies Regional exchanges vs. OTC (Hamilton 1979) Regional exchanges (Lee 1993) Purchased order flow (Battalio 1997) Nasdaq vs. ECNs (Barclay, Hendershott, McCormick 2003) Nasdaq vs. SuperMontage (Bessembinder 2003) Nasdaq vs. ECNs (Fink, Fink, Weston 2006) Euronext vs. LSE in the Dutch market (Foucault and Menkveld 2008) Home market vs. Turquoise (Hengelbrock and Theissen 2010) Euronext vs. Chi-X (Chlistalla and Lutat 2009 & 2011) Overall result: Competition seems to be good Findings from US markets hardly transferable to European landscape RegNMS vs. MiFID, e.g. trade through rule and best execution Centralized post-trade services, i.e. clearing and settlement 6

Observation periods and market developments Pre-MiFID phase MiFID live Turquoise launch Lehman crisis BATS launch Post-MiFID phase Euro / Greece crisis 2007/8/8 2007/10/31 60 days 2010/2/4 2010/4/30 60 days Time November 2007 August 2008 September 2008 November 2008 May 2010 8

Sampling procedure and dataset High fragmentation EURO-STOXX constituents from ten most-fragmented European markets Stocks closest to those from the other group in terms of free float market capitalization in the pre- MiFID phase Low fragmentation IBEX 35 represents Spanish blue chip stocks IBEX 35 index constituents that were also present in the EURO STOXX Permanent index constituents during both observation periods Adjusted data for stock splits according to split ratio 24 stock pairs classified into quartiles according to market cap Level-2 order book and trade data from Thomson Reuters Tick History for home markets and three main MTFs Snapshots for each order book every minute (without call auctions) Reconstruction of virtual pan-european consolidated order book 9

Liquidity measures Application of two inverse liquidity measures to the consolidated and home markets order books: Relative quoted spread Exchange Liquidity Measure (XLM) for values of 50k and 100k Euros (Gomber et al. 2004) XLM measures the execution costs of a round-trip transaction (incorporating potential market impact) BidSize BidLim AskLim AskSize BidSize BidLim AskLim AskSize 4236 BidSize 19.99 BidLim20.01 AskLim3233 AskSize 4236 19.99 20.01 3233 34634236 19.98 19.99 20.03 20.01 44373233 3463 19.98 20.03 4437 43873463 19.96 19.98 20.04 20.03 42364437 4387 19.96 20.04 4236 32334387 19.95 19.96 20.05 20.04 34634236 3233 19.95 20.05 3463 44373233 19.94 19.95 20.07 20.05 43873463 4437 19.94 20.07 4387 4437 19.94 20.07 4387 10

Regression model with liquidity measures as dependent variables Assumption that a dependent variable y i,t for stock i and day t can be expressed by adding up a stock-specific mean µ i of the respective liquidity measure, an event effect δ i, potential control variables X i,t and an error term ε i,t : Regression: y i,t = µ i + δ i I ε i,t = ξ t + ψ i,t 1 µ p = µ N i p i I p [ t in post - MiFID period] and 1 δ p = δ N i p i I p + β X i,t + ε i,t y i,t equals [relspread, XLM 50k, XLM 100k], X i,t represents the control variables price level, traded volume and volatility, I [t in post-mifid period] equals 1 if t lies within the post-mifid period and 0 else Application of Rogers standard errors to account for commonalities across stocks, heteroscedasticity, and non-zero stock-specific autocorrelation (Petersen 2009) 11

Overall liquidity changes for consolidated and home markets order books from pre- to post-mifid period EURO STOXX IBEX 35 31.27 +22% 30.68 Consolidated order books 11.04-25% 18.95-31% 13.13-43% 17.79 +5% 14.00 +16% 18.90 21.87 25.20 8.31 13.34 Spread XLM 50k XLM 100k Spread XLM 50k XLM 100k 31.27 31.59 Home Market order books 11.04-11% 9.78 18.95-12% 16.67-26% 23.15 +7% 13.34 14.25 +20% 18.90 22.60 +25% 25.20 Pre-MiFID Post-MiFID Spread XLM 50k XLM 100k Spead XLM 50k XLM 100k Note: Liquidity measured in basis points. 13

Liquidity changes for EURO STOXX instruments Consolidated Relative spread XLM 50K XLM 100K Change Q1 (δ1) -0.60 ** -1.64 ** -2.37 ** Rel. Change Q1-12.05% -12.74% -11.31% Change Q2 (δ2) -2.99 ** -4.70 ** -7.38 ** Rel. Change Q2-18.70% -24.59% -35.23% Change Q3 (δ3) -2.54 ** -4.36 ** -12.76 ** Rel. Change Q3-24.67% -14.86% -28.06% Change Q4 (δ4) -3.97 ** -14.95 ** -38.11 ** Rel. Change Q4-32.75% -46.80% -58.69% Change All Quartiles -2.10 ** -5.13 ** -12.65 ** Rel. Change All Quartiles -24.66% -30.70% -43.12% R2 0.30 0.25 0.21 No. of Observations 2880 2880 2880 Decrease of Relative spreads and XLMs Regression output suggests Significant positive impact of MiFID on liquidity in terms of relative spreads and XLMs Home Market Relative spread XLM 50K XLM 100K Change Q1 (δ1) 0.64 ** 0.83 ** 0.38 Rel. Change Q1 6.76% 22.97% 26.60% Change Q2 (δ2) -1.65 ** -2.12 ** -4.43 ** Rel. Change Q2-1.70% -2.56% -16.50% Change Q3 (δ3) -1.28 ** -1.02-7.14 ** Rel. Change Q3-12.64% 4.36% -6.73% Change Q4 (δ4) -2.67 ** -10.96 ** -31.26 ** Rel. Change Q4-22.67% -33.46% -47.32% Change All Quartiles -0.91 ** -2.17 ** -8.13 ** Rel. Change All Quartiles -11.39% -12.00% -25.97% R2 0.26 0.19 0.17 No. of Observations 2880 2880 2880 * / ** significant at 95 / 99 percent level Decrease of Relative spreads and XLMs Changes are less pronounced Regression output suggests Significant positive impact of MiFID on liquidity in terms of relative spreads and XLMs, except for Q1 14

Liquidity changes for Spanish IBEX 35 instruments Consolidated Relative spread XLM 50K XLM 100K Change Q1 (δ1) -0.29-0.69-1.04 Rel. Change Q1-4.61% -0.15% 3.21% Change Q2 (δ2) 2.16 ** 1.54 ** 0.42 Rel. Change Q2 10.12% 8.92% 7.74% Change Q3 (δ3) 3.09 ** 4.25 ** 5.36 ** Rel. Change Q3 26.26% 33.05% 34.53% Change Q4 (δ4) -2.14 ** 1.84 ** 6.90 ** Rel. Change Q4-10.28% 10.58% 24.97% Change All Quartiles 0.85 * 2.44 ** 4.24 ** Rel. Change All Quartiles 4.96% 15.68% 21.75% R2 0.20 0.28 0.30 No. of Observations 2880 2880 2880 Order books show Heterogeneous development of relative spreads and XLMs across quartiles, but overall increase Regression output suggests Heterogeneous, mostly significant negative impact on consolidated liquidity Home Market Relative spread XLM 50K XLM 100K Change Q1 (δ1) 0.02-0.35-0.55 Rel. Change Q1-0.09% 3.80% 8.20% Change Q2 (δ2) 2.45 ** 2.10 ** 1.24 Rel. Change Q2 12.46% 11.94% 11.16% Change Q3 (δ3) 3.25 ** 5.24 ** 6.29 ** Rel. Change Q3 27.55% 38.11% 37.73% Change Q4 (δ4) -1.92 ** 2.76 ** 8.16 ** Rel. Change Q4-9.22% 14.06% 28.70% Change All Quartiles 1.09 ** 3.12 ** 5.09 ** Rel. Change All Quartiles 6.87% 19.58% 25.37% R2 0.20 0.28 0.30 No. of Observations 2880 2880 2880 * / ** significant at 95 / 99 percent level Spanish home market developed similarly to the consolidated book More pronounced deterioration than in consolidated book Main liquidity contribution of MTFs limited to Q1 stocks Regression output suggests Mostly significant negative development of liquidity since MiFID introduction 15

Analysis of market integrity - Methodology Closing price is of special importance due to reference price function (Aitken et al. 2005) Calculate portfolio returns Determine a fund s net asset value (NAV) Benchmark traders performance Fragmentation of order flow potentially eases price manipulation Analysis of ramping incidents before and after applicability of MiFID (Aitken and Siow 2003) Returns are sampled every 15 minutes and sorted in descending order for each trading day Closing interval s return among top 1 percent indicates a ramping incident Total of 194 securities analyzed over period of twelve months 16

Average number of ramping incidents per security in the index samples during the observation periods pre-mifid post-mifid Change FTSE 100 0 0.088 0.088 DAX 30 0.28 0.28 ±0.000 CAC 40 1.243 0.297-0.946 MIB 30 0.28 0.48 0.2 IBEX 35 0.667 0.833 0.167 Results are ambiguous regarding the different index samples and observation periods No clear European trend in the number of ramping incidents Home markets closing call auctions robust enough to prevent manipulation No evidence of market integrity suffering from fragmentation of order flow 17

Conclusions and limitations from MiFID impact study Conclusions Positive liquidity effect in EURO STOXX equities between pre and post MiFID period Direct effect from new markets Indirect effect observable in the home market Positive liquidity effect not found in market with low competition Barriers in post-trade processes obviously inhibit inter-market competition Concerns over fragmentation inappropriate Results concerning market integrity are ambiguous across European blue chip indices Findings provide relevant input for MiFID II which is expected for mid 2012 Limitations Long period between pre- and post-mifid observations; factors other than fragmentation might have affected market liquidity, e.g. Algorithmic Trading / HFT Reduction of tick size and explicit trading fees represent additional changes to the microstructure of European markets 18

Characteristics of technical platforms aiming to integrate post-trading services in Europe TARGET2-Securities Platform for CSDs provided by the Eurosystem on a not-for-profit basis Settlement services in central bank money Start planned for 2014 SSE / ESES Platforms for all seven markets where Euroclear is providing post-trade services Settlement and custody services in commercial and central bank money Already implemented Link Up Markets Platform for post-trading services for ten CSDs Settlement and custody services in commercial and central bank money Includes ten countries Already implemented Cascade / Creation Platforms for Germany and Luxembourg providing post-trading services Settlement and custody services in commercial and central bank money Already implemented Research approach for analysis: Case study with managers of institutions in the post-trading industry that are currently planning or already offering post-trading services by applying semistructured questionnaires Key result: Technical platforms aiming to integrate securities settlement don t address aspects of shareholder visibility yet, but could help to integrate the different national systems and be basis for creation of European shareholder register 20

Thank you for your attention! Prof. Dr. Peter Gomber E-Finance Lab University of Frankfurt