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J.C. Louis
J.C. Louis
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Crossing Networks Oust the Middleman in Europe

Three crossing networks have sprung up on the European continent allowing buy side fund managers to trade directly with each other. Two are owned by a consortium of financial institutions, signaling a trend toward for-profit trading systems.

Cross border trading of European equities is getting a push from electronic crossing networks that would bypass the traditional exchanges completely. The much heralded "superbourse'-a pan-European equity platform joining the London and Frankfort exchanges to those in the continent's five other largest financial capitols-has floundered over the last year amid disagreements over regulatory harmonization and the choice of a common trading platform. This fragmentation coupled with the demand for anonymity from the buy side investment community has sparked interest in crossing networks-systems that match buy and sell orders without an intermediary and can lower transaction costs by as much as 80%. Answering that call is ITG Europe's Posit, an electronic crossing system launched last November, that will increase its scope early next year from 2,500 UK stocks to 5,000 UK and European stocks listed on exchanges from Germany, France and Spain to Holland Switzerland and Belgium. In July, nineteen UK fund managers established E-Crossnet Ltd., a crossing network for UK and other European equities, exclusively targeted at institutional fund managers, which is slated for launch during the first quarter of next year. Lead consortium members-Barclays Global Investors (BGI) and Merrill Lynch Mercury Asset Management (MAM)-own 50% of the system, but the other 19 fund management firms will also be eligible to buy a piece of the company. While BGI and MAM already conducted bilateral crosses between each other, their goal was create a trading platform that could handle multilateral crosses involving multiple stocks and counterparties.

A third contender is Tradepoint, an order-driven electronic exchange for UK securities that received a $22.9 million rescue package in July from a diverse group of American investors, which includes Instinet Corp., the U.S. investment banks Morgan Stanley Dean Witter and J.P. Morgan as well as Warburg, Dillion Read; the ECN Archipelago, and American Century, the U.S.-based mutual fund company. Founded in 1996 as a rival to the London Stock Exchange, Tradepoint's new owners are changing the strategy. Among the ideas mentioned are after hours trading and dealing in continental European and U.S. stocks. Tradepoint is the first foreign exchange to receive SEC approval to operate in the U.S.

While the proliferation of crossing networks in Europe mirrors the trend toward electronic communications networks (ECNs) in the United States, there are some fundamental differences. Unlike in the U.S., notes Benn Steil, senior fellow in economics at the Council of Foreign Relations, European exchanges function individually as fully- electronic auction markets, thus obviating any significant role for U.S.-style ECNs like Instinet or Island, electronic matching systems that display firm, priced orders to other participants, and executes automatically against other orders in the system. Nevertheless, adds Alasdair Haynes, chief executive of ITG Europe, lack of harmonization in trading rules, settlements and clearing continue to fragment European equity markets, and leave established exchanges exposed to another kind of U.S.-style alternative trading system-crossing networks.

As the first crossing system in Europe, Posit is recording almost $1 billion per day in U.K. stock trades involving 96 clients. "The benefits of pure anonymity and mid point prices allows reduction of market impact," adds Haynes, whose ITG Europe is a 50-50 joint venture of Societe Generale and ITG, a U.S. technology company that operates a crossing network-Posit-for U.S. stocks.

The benefits don't stop there. "Crossing eliminates bid-offer spreads, resulting in substantial cost savings," observes Nigel Foster, chief executive of E-Crossnet and formerly of MAM. Bid offer spreads widen with increased volume, making impact of market entry the highest component of transaction costs. Beyond these dedicated crossing platforms, Instinet, the global agency broker which is a member of 17 stock exchanges and operates in 40 markets, offers crossing of U.S. and European stocks as part of its overall broker-agency function. A user can choose to post an order on the Instinet system or have it sent to an exchange. Tradepoint is a London-based for-profit electronic exchange with crossing capability. "Tradepoint runs a fully-transparent open order book on an anonymous basis that has exchange status," explains Tradepoint CEO Richard Kilsby. "The crossing network becomes one of several order routing mechanisms. We can run different types of auctions, like a Posit-type blind cross or a transaction with a more complex pricing measure, such as VWAP" (Volume Weighted Average Price).

Like E-Crossnet, Tradepoint, since the July financing, is owned by a diverse consortium of buy-side, sell side and ECNs whose interests appear more diverse than E-Crossnet's buy side members. "They're really all driving down the same route," intones Kilsby, who believes Tradepoint may offer a business model that resets the paradigm for electronic trading systems-shareholders are actually stakeholders who add value either through the sell-side broker-dealer function of facilitating trading or the buy-side institutional function of providing order flow liquidity. Eventually, Kilsby envisions, equity stakes in electronic trading ventures could actually float in proportion to each consortium member's value added over a given time.

While Tradepoint and the other crossing networks have been portrayed as competitors to the stock exchanges, their relationship is more symbiotic. That's because the crossing networks provide no price discovery of their own and in fact depend on the exchanges for that. If the crossing networks were to take away too much volume from the exchanges, they would impact the price discovery process upon which they depend ... Tradepoint's 80 members, including brokers and money managers, currently handle less than 0.5% of the trading volume in London shares, according to published reports. It needs a 2% market share to just reach the financial break-even point.

User Consortium to Rival Posit?

But to some extent, the new crossing networks will be competing with each other. For instance, E-Crossnet's consortium offers members considerable capital gain that they would miss if they traded on POSIT. "The emergence of E-Crossnet could force either radical enhancement of Posit services or the end of Posit's preeminence in the U.K.," speculated one well-informed industry player.

Another point of contention is whether or not to admit brokers as participants. Having built on its members well-established bi-lateral crossing relationships, E-Crossnet is limiting participation to a broadening circle of buy-side institutions. "Such investors have similar interests," asserts Nigel Foster. "They need to have absolute confidence in the system before committing their full order book." According to Andrew Skirton, CIO, BGI Europe, "Having brokers and market makers as participants invites shorter term trading activity." "That matters less in situations where business is mature." In the development phase, there's a distinct benefit to having only long term investors," says Skirton, who acknowledges there is a fear that brokers will game the crossing system.

The opposing view-that dealers provide significant incremental liquidity against which crosses can execute-reflects the preferences of Posit and Tradepoint users, whose orders are exposed to all parties unless they opt to "tier" out broker dealers and market makers. Some suggest a two-step model that exposes institutions to one another's liquidity, with unmatched residual flow run against a subsequent cross open to sell-side players. "Broker-dealers want to see the residuals," asserts one observer. "The information on what comes back can be extremely valuable."

Cross Border Crosses

POSIT has accelerated competitive enhancements, including powerful algorithms for intelligent routing of initial crosses and residual orders. Regarding residuals, observes Haynes, "there are academic, quantitative approaches to trade at maximum point of liquidity. We can chart the 'liquidity smile' for the most liquid times of day. ITG has a product with low impact execution models and pre-trade analysis." These are coming to ITG Europe, adds Haynes, "but they won't turn up tomorrow." Next quarter, POSIT will incorporate a proprietary feature to exploit regulatory loopholes in country's like France that prohibit trading outside the quote current when the cross was entered. For example, explains Haynes, if the stock mid-point price moves from 100 to say 101 once the cross has been initiated-the algorithm could take something like forty seconds-the cross cannot legally be executed. "There are mechanisms to be outside the quote and yet complete the trade within French law that have the approval of the French exchange," says Haynes. On the back-end, POSIT has a highly automated straight-through processing engine that tracks the continent's myriad regulatory and settlement regimes. "POSIT created a single uniform crossing platform for trading and transaction reporting in every European capital," says Haynes. "The customer could deal in three stocks in different countries and currencies yet see one contract note." Ease of use and straight-through order processing are prime considerations for E-Crossnet too. "We've been told to 'stick to our knitting. Keep the algorithm simple'," says BGI's Skirton, adding that there are myriad price formations for various crosses including last sale, mid price, or VWAP. A cross in U.K. might use a different formula than one in Germany. Small caps may have a different crossing price formula from more liquid large caps. "The more you can specifically define or 'theme' the crosses, the more likely you can create attractive crossing rates."

E-Crossnet's front end has yet to be selected."That is the horse race," says Skirton. Trading desks will use a system only if they can interact with it easily. We want an infrastructure to input orders, receive confirmations and send residual orders back out." E-Crossnet's back-end will be outsourced to a highly accredited yet-to-be-named clearing firm that will administrate all back-end functions, including confirmation of crossing prices, trade reporting to exchanges and settlement.

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