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Liquidity, transparency and fragmentation in equity markets

Reading one of John Cant’s recent blogs, I thought that we should remind ourselves that off-exchange trading existed before MiFID.  50% of UK trading in UK equities has been taking place away from the computer systems of the London Stock Exchange for quite some time now.  30%-50% of equity trading across Europe has been taking place off-exchange (the percentage depending on which country we are talking about), despite any concentration rules that may have existed. 

So before MiFID existed we already had a fragmented market.  MiFID doesn’t cause fragmentation – it accepts that it already exists, it makes allowance for fragmentation, and it even encourages fragmentation.  But only if the client gets better execution as a result.  Somebody who drafted MiFID recognised that a natural economic balance exists between fragmentation and best execution, and that this economic balance will be achieved naturally if it is left to market forces and market participants.

Liquidity has three dimensions: how much of an item can you trade, how quickly, and how much does the price move as a result.  Liquidity in European equities has always been fragmented: how much more fragmented does it have to get if 50% of trading can already be off-exchange?

Perhaps more importantly, transparency is now more fragmented.  In the past, an equity exchange could demand that all of its members give the exchange their trading data.  MiFID says that exchanges can no longer demand this data, and so an exchange is not necessarily the single central point for national market transparency any more.  But most exchanges never collected all trading data from all market participants in any case.

When Mrs Thatcher tried to close down the Greater London Council (GLC) back in the 1980s, one thing her government did was to televise interviews with the “man in the street” to ask what the GLC actually did for them.  Most London residents got it all wrong, thinking that the GLC did things that were in fact the responsibility of the local council.  Very few residents who lived within the area coordinated by the GLC knew the truth of what the GLC actually did for them and what they were paying the GLC to do.

MiFID is a “wake up and smell the coffee” kind of experience.  If exchanges really did all the things that everyone thought exchanges did, and that everyone thought that exchanges should have done, MiFID would never have been written.  Nobody wants to see exchanges disappear.  But we all need to be clear about the correct answers to the question:

“What did the Exchanges ever do for us?”

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