TABB Group, the research and advisory firm, recently published a report claiming only two-thirds of UK equity turnover represents actual executable liquidity, with the rest made up of double-counting and noise. That means the UK equities market is not nearly as deep as it may have at first appeared, the authors say. Regulators should take note, says Will Rhode, TABB Group research analyst and one of the reports authors
GC: What prompted you to research UK equity turnover?
Rhode: The purpose was to try to break down the UK markets and understand a little more about how trades are conducted across execution venue and channel. We chose to focus on the UK since its the biggest one in Europe, and has the widest variation in terms of order flow. As a result, we ended up addressing not just how much of the market is attributed to high-frequency trading but also what portion of OTC trading constituted meaningful, executable liquidity.
GC: Explain the concept of noise that you raise in your report. How is it that reprints of already-conducted trades have been double-counted, so to speak, all this time?
Rhode: Up until now, the way in which the equity markets have been analyzed has been two-dimensional, looking at OTC versus exchange. This is what comes out of the trade report data that you might see as reported by Reuters, if you will. This two-dimensional view of the markets is not really a helpful way to look at it. For starters, the OTC market is populated by equity-related activity that doesnt necessarily equate to the same kind of activity you might find on an order book, and there is a high degree of so-called noise on the OTC print.
The noise refers to a reprint. A reprint would occur, for example, as part of the give-up process associated with contracts-for-difference (CFD) trading in the UK. This is where a broker takes receipt of an underlying equity hedge associated with the CFD from another executing broker as part of best execution practice. In this case, the equity hedge will be given up to the CFD provider, and even though that provider has not in fact transacted the transaction, they will print the receipt of the equity on the OTC print. So that is an example of a reprint.
GC: You have been quoted saying your findings could have a far-reaching impact, perhaps even on regulation. How could it affect legislation in the UK, or even outside the UK?
Rhode: As you are probably aware, the principal piece of regulation at the front of peoples minds is the MiFID Review. It is a pan-European piece of regulation concerning the transparency in the equity markets. The way in which we see that this research may have an effect in terms of future regulation is that regulators will now have an accurate picture of equity market activity before implementing changes. For example, if you take the traditional debate in Europe about how much activity occurs in the broker crossing networks, there has been a very broad discrepancy in terms of estimates by various interested parties. Our findings show that while we see BCS activity in the UK at 5% on a total turnover basis, this rises to 8% when you cut out the reprints and noise on the OTC print. Thats an example of how this research paints a more accurate picture of the equity market activity in the UK, and is a more accurate basis upon which to make regulatory decisions.
GC: Does the CFD phenomenon you describe occur in markets outside the UK?
Rhode: Investors or traders that wish to participate in the performance of a share but do not necessarily want to take up a delivery of shares use CFDs. A principal reason being that CFDs are exempt from stamp duty, while equities are not. Stamp duty applies only in certain markets elsewhere. Hong Kong imposes a stamp duty on shares, for example. In the US, equity swaps are not used as widely, so youre not going to find the same level of use of equity swaps in the US as in the UK. However, we do see activity increasing in Europe particularly with new hedge fund regulation and the growth of UCITS III funds. UCITS III funds have certain restrictions in terms of their ability to short the market. To go short, they have to use CFDs. As a result of the growth in UCITS III funds, then, we see increasing use of CFDs going forward.
GC: In the short term, what should we take away from this report?
Rhode: The main finding of the research is that trade reports give a very incomplete picture of the way equities transact in the market. In order for good regulation to go forward and better decisions to be made, I think better transparency in terms of trade reports should become a priority.
Christopher Gohlke