'Smart' Bombs to Ignite Liquidity Explosion

Just as 2007 was the year of MiFID, we believe that 2008 will be the year for smart people to use smart order routing, and that ultimately competition-not consolidation-among trading venues will drive down the cost of trading in Europe. We fully supported the efforts of European regulators to allow new European execution venues, and are proud to have launched the first live European Multilateral Trading Facility, which has shown modestly encouraging early volumes in UK, German, Dutch, French and Swiss stocks.

But 2008 will be the year for greatly anticipated new entrants. Alongside Chi-X Europe, these will provide competition for the trading community. Historically, traders have only needed to check the price of a stock on its underlying stock exchange. But in future, as a result of Best Execution responsibilities, they will need to check a variety of venues for the "best possible result," and will need to use smart order routers-highly-sophisticated algorithms that analyze multiple streams of market data to simultaneously compare the price of a security across all the available venues on which it is traded.

In fact, smart order routers must not simply compare prices, but also factor in additional fees such as the underlying clearing and settlement costs of execution. Successful smart order routers will judge where to get the best possible price at the lowest possible cost, will execute accordingly and immediately re-evaluate the constantly changing state of the market. In order to return the greatest value, firms will need the smartest order routers as true competition comes into effect, and we anticipate considerable investment in truly smart order routing.

Before building Chi-X Europe, we examined the US ECN model and assessed the lessons to be learned before approaching the more complex European market infrastructure. One significant difference between the US and Europe is the question of who carries the responsibility for smart order routing. In the US, exchanges and ECNs themselves must check other venues and onward-route orders if a better execution is available elsewhere. In Europe, however, responsibility for market comparison lies with the trading community rather than the venues themselves. We believe that the market will evolve to require the venues themselves to onward-route orders, which is ultimately a more efficient market model. However, we also suspect that day-when exchanges will onward-route orders-may be some way off yet.

Another area expected to come under increased scrutiny in 2008 will be the European clearing market model. As an integral element of trading costs, we anticipate growing pressure to reduce clearing fees. The current vertical model-whereby each exchange uses a dedicated clearing counterparty (CCP)-has remained static for several years, and only in 2007 was any new form of competition introduced.

EMCF (the European Multilateral Clearing Facility), owned and operated by Fortis, was launched in 2007 to provide a virtual, pan-European CCP for all Chi-X Europe trading. EMCF then interacts with the underlying securities depositories to settle the trades. Since launch, this new, virtual model has reduced clearing costs by an average of 50 percent. EMCF has proved that competition in the clearing space can reduce the overall brokerage costs borne by the trading community which, in turn, provides better margins.

Firms can connect to venues including Chi-X Europe via a range of low-latency connectivity and proximity hosting providers that take clients closer to their end goal of near-zero latency.

Latency, however, is only one part of the equation. Since speed to market is so important, we must also examine to what degree the exchanges can handle the increasing volumes of quotes and trades being pumped through them. Fast input and output speeds help high-frequency traders connect to exchanges, but if the execution venues' capacities are unable to handle the orders, this results in clumping and queuing.

Traders who use smart order-routing algorithms to find the best possible execution opportunity will not be able to execute their orders at the anticipated price if the exchange cannot accept the orders at the pace they are sent. Chi-X Europe's capacity of 30,000 messages per second is designed to be fully scaleable in anticipation of future demand. We suspect that the incumbent exchanges will be keen to review their own capacities, and we fully expect further developments in this area.

These are very interesting and positive times for the European marketplace. Many are heralding the entrance of new venues as a fight for existing liquidity. We don't see this at all. It is not a zero-sum game. Since going live, we have seen new liquidity in the form of high-frequency trading business that has historically struggled to be executed in Europe due to prohibitive costs or limited capacities.

We believe instead that new competition is helping Europe become more attractive to both profiles of investors, and markets are starting to segment into those catering for order size, and others-like us-for speed. Importantly, the overall costs of trading and clearing are falling, and long may this continue.