The impact of regulation and fragmentation on the current liquidity landscape

The ever-changing liquidity landscape is characterized by the availability and ease with which assets can be bought and sold without significant price changes. Particularly in Europe, we are witnessing changes in these dynamics, as well as an increasing fragmentation of liquidity in the region.

This landscape has experienced significant changes in recent years due to technological advancements, increased market share and regulatory changes. Understanding the current liquidity landscape allows investors to optimize their strategies, manage risk more effectively, and make informed decisions in both stable and turbulent market environments. The topic of liquidity and its dynamics of change has been a key topic in the industry at various conferences organized over the last few months.

Read more: Tackling liquidity challenges in Europe requires caution, especially when considering alternative ways of trading

Speaking to The TRADE about key themes in this space, Mark Montgomery, head of strategy and business development at big xyt, notes: “We have made a change to the RTS 1 and 2 OTC trading flags. This sounds boring as a commentary, but underneath the surface it has significant meaning; what actually happened was that by engaging the FIX community and listening to regulators, they removed much of the noise that was creating unaddressable volumes in the market.

“The most important thing in all of this are transactions that are concluded off the book, off the market, off the exchange and do not contribute to price formation – that is, they are noise, they are synthetic transactions or they cannot be undertaken or addressed – we have seen evidence of a large a decline in this phenomenon, and we have also seen more detailed and better marking of transactions with specific characteristics.”

Montgomery then added that benchmark-based trades, which may be software trades tied to something or trades that were previously a bit obscure, have more granularity in terms of marking and noise reduction.

“One of the challenges in all of this is watching the percentages fluctuate. Because OTC has been so large, the growth of some of the other mechanisms may seem disproportionately large, but in terms of value we will have to look a little deeper and see what this means for the subcategory,” adds Montgomery.

Electronic liquidity providers

Another key theme highlighted by Montgomery is the two-sided liquidity provision offered by electronic liquidity providers. It notes that these providers “previously provided liquidity to markets in the way they interacted with exchanges and were known to some people in the community, but not to all.” However, today we see that ELPs are more active and vocal about their resolutions and offers.”

Speaking to The TRADE about the evolution of buy-side ELPs, Anish Puaar, head of European equities structure at Optiver, adds: “We see more interaction between buy-side firms and ELPs in equities, e.g. directly or through SIs . The liquidity offered by ELP is another channel that the buy-side can leverage alongside other execution options.” Optiver currently connects directly to the buyer side through fulfillment management systems (EMS).

“As with all participants, we believe it is important for ELPs to be open and transparent about how they provide liquidity. As buy-side interactions with ELPs increase, it is important to ensure that the nature of these interactions is well understood,” says Puaar.

Reporting

Elsewhere, Montgomery discussed the nature of ELP reporting in relation to the SI mechanism. “It appears that ELPs are not necessarily reporting their trades in the way we expected, through an AI mechanism, as this would appear systematic and risky. But in fact, in some cases, they do it by waiving off-the-book (exchange) payments,” he says.

This means that there has been an interesting shift in the market in terms of risk assurance and transfer.

“If I’m a buy side and I suddenly want to trade rather than broker a trade using the regular VWAP algorithm, I’m suddenly trading with risk,” adds Montgomery. “It might be in a block or intraday with a risk counterparty, where I give a little more information to someone who can do more in terms of price movement, access to other markets and other places with that information and with that flow.”

This may ultimately result in a shift from bank risk roles to ELP risk roles. Montgomery explains that this is “something that banks will be looking at very closely, and I think it’s something that ELPs will be looking for to see how they manage this risk.”