Competition for order flow in FTSE 100 securities is fierce and increasing. Within the past two years the London Stock Exchange’s share of exchange order flow has fallen from nearly 100% to less than 65% at the end of 2009. The current situation is such that regulators are concerned about price formation in the stocks that make up the FTSE 100, the leading U.K. stock market index. In this paper we study the competition for order flow and market quality, including price discovery and liquidity in FTSE 100 constituents. We investigate the implications of MiFID in FTSE 100 constituents as the MTF market share is highest in these shares.
The Markets in Financial Instruments Directive (MiFID) is designed to promote an integrated and harmonized European financial trading landscape. MiFID increased the competition for order flow between regulated markets (RM) and other trading venues with the repeal of the concentration rule that stipulated the execution of retail orders on RMs. The concentration rule lead to a situation where a single stock exchange dominated in each member state. This situation is different to the U.S. market where markets are more fragmented but virtually integrated via the consolidated tape and the consolidated quotation system. The lack of competition was addressed with the implementation of MiFID on November 1st, 2007 after which orders could be executed away from the RM on multilateral trading facilities (MTF) or system-internalizers (SI).
The MiFID introduced further competition in European security markets with its policy on best execution. Under MiFID best execution is multi-dimensional, in that price is not the only factor. The obligation to define and enforce a best execution policy is placed in intermediares (e.g. brokers or banks), the results of which are unclear. The best execution policy in U.S. securities markets is a best price policy (see: Rule 602 b, Regulation NMS (Reg NMS)), where the onus to enforce the policy is on the trading venue to which an order is routed (see: Rule 611, Reg NMS). These differences can lead to competition on price or on other factors outlined in MiFID such as speed, probability of execution, or probability of settlement. In consequence, the best available price might be traded-through.
The important question is whether or not market fragmentation is beneficial for price discovery. We believe that this question is central for the evaluation of European capital markets under MiFID. Efficient prices are a public good and critical to efficient investment and risk management decision making. Conventional wisdom suggests that liquidity begets liquidity, i.e. liquidity externalties arise when traders meet on centralized market places. The consolidation of order flow reduces trading and search costs for investors and thus, could enhance price discovery. Pagano (1989a,b) and Chowdhry and Nanda (1991) show that there are strong incentitives to concentrate order flow if trading is equally costly across trading venues. However, investors might have different preferences. While high frequency traders seek for low-latency network connections, average investors might for example prefer specific pre- or post-trade services. As a result, concentration might be suboptimal.
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Fragmentation, Competition and Market Quality: A Post-MiFID Analysis
