The New Year heralded the fact that based on due diligence being conducted, Chi-X Europe being acquired by BATS Global Markets should be a mere formality.
Having been involved with Chi-X from the outset until February last year, I must admit that its forthcoming inevitable demise will be the end of an era. It has served as the only real example against all the odds of a successful competitor succeeding against the established exchanges. However there is no point being nostalgic as the needs and structure of markets change. There was a need for a cash equities challenger when Chi-X was launched ahead of MiFID going live in March 2007 given rising prices and compliancy from some of the more established exchanges. However since then the cash equities business has become more commoditised, with margins and volumes falling resulting in the “pile it high, sell it cheap model” no longer being sustainable especially when staying up with technological advances and market developments requires continual major capital expenditure. Chi-X Europe managed to succeed here on the back of having first mover advantage, the right types of players trading on it with some also as shareholders and good technology at the time. Others have not been so lucky when trying to follow its footsteps.
However over time this success may have been seriously challenged given that faster trading platforms have emerged in Europe with Turquoise upgrading its platform to Millennium in Q4 2010 with the LSE soon to follow on 14 February this year. Bats also operates faster technology than Chi-X Europe and Plus Markets Group is looking to upgrade to our AlgoM2 matching engine during 2011. All this would have meant that where Chi-X Europe succeeded in part because it had a faster platform, overtime the tables would have been turned and potentially liquidity on it impacted on the back of having not kept pace with the technology arms race. Speed is important for exchange trading platforms because it reduces exposure time for the liquidity providers from the time that for example news breaks to the time it takes for them to update their quotes on exchange. Where this exposure time is less, it can lead to tighter spreads and more depth of liquidity and therefore potentially more market share.
Additionally the race in Europe especially in 2011 is very much shifting towards derivatives with the CME looking to come in and new challengers like Turquoise and Plus Markets looking to launch a derivatives offering during the first part of 2011 and aggressively challenge the European incumbents such as Eurex and NYSE Liffe who according to statistics from the Federation of European Stock Exchanges (FESE) hold 70% and 25% of the European equity derivatives markets respectively. NYSE meanwhile to counter threats is looking to harmonise its technology across different exchanges/ asset classes in its portfolio and harmonise clearing on the basis of it being internally run as such a move through its margin offset benefits helps the cash market flow protect the derivatives flow and vice versa ensuring economies of scale. MiFID 2 will also potentially open up opportunity across other OTC derivatives products and bring them on exchange.
Chi-X Europe did indicate that it wanted to penetrate the equity derivatives space too, but time to market would have been an issue given that the CME can leverage its US technology and Turquoise can easily leverage the SOLA platform LSE Group licensed from TMX Group and already uses for the Italian Derivatives Market (IDEM) and EDX. These organisations can also leverage existing clearing capabilities and tailor them for such an initiative. For Chi-X Europe, despite having a strong balance sheet to fund such an initiative, building this capability from scratch would have taken at least 12 months whilst the others stole a march and during this time its own large cash equities market share would have come under attack from these faster multi asset class offerings.
Therefore the option the board probably faced was, do we go it alone knowing the dynamic is changing with the knowledge that additional value could be created on the back of new asset classes but on the flip side there was also additional risk in terms of being challenged and regulatory changes as part of MiFID 2 also potentially leading to the erosion of some advantages. Or alternatively do we seek to exit now given the immense value created and avoid such risks and show a healthy mark up on the books for the investment. The latter obviously won the day and with in excess of 50% shareholder cross over between Bats and Chi-X Europe and a general view that having a genuine competitor in Europe to the large exchanges would keep prices low and the exchanges honest, the Bats deal always seemed the most likely one compared to NASDAQ OMX or NYSE Euronext assuming expectations were met in terms of valuation.
The combined group also has more strength as Bats has struggled to establish a strong foothold in Europe and therefore a combined entity provides a strong US and European presence, which is the perfect spring board to try and establish itself in Asia and become the first global exchange in terms of secondary market trading. Here it makes sense for the group to also look at acquiring parts of Chi-X Global such as Chi-X Japan to expedite this as well as possibly Chi-X Canada. The Bats technology can be utilised across such a group ensuring lower costs on the back of scale and Bat’s multi asset capabilities given the options exchange in the US can also be leveraged to offer derivatives in Europe as another challenger in that space. All of a sudden in a matter of a few years coming from now where you then have a truly multi asset class global exchange group, trumping NYSE, NASDAQ OMX and CME who appear to have ambitions to try and achieve this.
Such an entity could ultimately provide its shareholders with a very valuable exit based on an IPO over the next few years and reports in early January already seem to indicate that Bats are seriously exploring this option.
Assuming the deal concludes this quarter, what could the likely next steps be in practical terms? The integration is likely to take the best part of this year in terms of migrating the flow from Chi-X Europe onto the Bats platform. This also carries with it inherent risks given the complexity of such projects but also more so given that there are common trading strategies and clients across both platforms leading to some cross over in trading flow in addition to the shareholder cross over that already exists. There is a lesson to be learnt from the US. When Instinet acquired Island in June 2002, from memory given I was at Instinet at the time, both entities had about 20% each NASDAQ market share. The combined entity did not add up to 40% and in fact ended up around 25%. As such 30% Chi-X Europe FTSE 100 market share and 10% Bats market share will not add up to 40% and in fact the question remains whether this remains at 30% ticks up by a few percent or indeed if the migration does not go so well, whether there is some market share loss. Most clients that connect to Bats Europe also connect to Chi-X Europe but the same cannot be said the other way round. The HFT firms have the same or similar strategies deployed across both platforms. As such a merger of 2 order books into one will mean that trading firms utilising such strategies seek alternative arbitrage opportunities on other venues.
In my view there is a way to negate the threat of market share reduction and again here a lesson can be learnt from the US. Exchanges like Direct Edge successfully pioneered the idea of 2 parallel order books with different pricing dynamics that led to more liquidity overall within the ecosystem of the trading venue. Other venues such as NASDAQ OMX and Bats US have also followed suit with this. Bats would be wise to also extend this strategy into Europe and from an operational and technical perspective merge both platforms onto the Bats technology therefore reducing costs by having a lower technology and personnel foot print, however keep Chi-X Europe as an order book running in parallel with Bats Europe and differentiate them in terms of their pricing model. This would continue to allow firms to seek out opportunity across both books using similar strategies and also help more flow to remain within the group rather than go back to alternative markets centres. Bats Europe could then also go one step further and possibly apply for fully fledged regulated market status in the UK as it has done in the US to seek out even more opportunity as part of the MiFID review. A regulated market is allowed to operate an MTF as the LSE does with Turquoise and as Euronext do with Smartpool and NYSE Arca Europe.
Whatever happens, European markets will have undergone a stepped change over the last few years with fragmentation and then consolidation. One thing which has been proven is that competition is possible through innovation even with a back drop of great regulatory change. This leads to a glimmer of hope in potentially even more greatly regulated markets going forward that the market whatever asset class is traded will find a natural balance and adapt in ways that make it more efficient. As such when one door closes another opens.
About the Author
Hirander Misra is the co-founder of both companies and is responsible for running Algo Technologies to deliver specialist high speed trading technology solutions which include extremely low latency distributed raw and normalised market data (AlgoData), matching technology with the world’s fastest independently verified matching engine (AlgoM2) and shortest path inter exchange network connectivity (AlgoSpan) with the added advantage of expert market structure consultancy services.