Global trends in market fragmentation and their impact on brokers and technology

key takeaways

• A range of factors is driving increased market fragmentation in Europe and North America, including the growth of retail trading.
• Fragmentation poses increasing operational and regulatory challenges for brokers.
• Technological solutions can help brokers to streamline their processes and control the costs of operating in a fragmented market landscape.

Market fragmentation is growing in Europe and North America. Trading is increasingly carried out away from exchanges, and even on-exchange volume is split between a range of different facilities. However, the picture is country-specific, and some markets have gone further down the path of fragmentation than others. Around 50% of equity market volume in the US is traded off-exchange, as reported by official FINRA Trade Reporting Facilities (TRFs). Meanwhile, around 70% of traded volume in Europe is on-exchange, according to data from the Association of Financial Markets in Europe (AFME). However, even within the on-exchange space, there is still considerable fragmentation. A recent Oxera report shows how traded volume in the UK is split between lit order books, auctions, dark venues, Systematic Internalizers (SIs), and more.

What is driving market fragmentation?

Various factors and reasons drive market fragmentation, including the growth of specialist venues such as Alternative Trading Systems (ATSs) in the US and Multilateral Trading Facilities (MTFs) in Europe. Many of these venues service demands for a specific type of trading. For example, dark pools which allow firms to handle large venues without revealing too much information to the market. The recent growth in venues offering extended market hours in the US is another example of specialized trading requirements driving fragmentation.

New venues and trading facilities have also appeared in Europe in response to multiple waves of MiFID II regulation. While this was intended to improve price discovery and concentrate business in lit markets, it has led to the growth of a range of alternative venues, including SIs and periodic auction markets.

The growth of retail trading (serviced by a new generation of neo-brokers) also contributes to fragmentation. These firms aim to attract business by charging zero commission on trades. Instead, they make a significant proportion of their revenue from payment for order flow from trading venues. This drives them to route orders to market makers. Market makers tend to try to match these orders internally, rather than trade them on exchanges, as this saves on exchange fees and minimizes trading risk. Increasing amounts of retail volume are therefore being traded off-exchange.

Exchanges have responded to this process with various innovations designed to win back retail flow. For example, Cboe’s EDGX exchange allows retail orders to take priority over non-retail flow at the same price level, aiming to improve execution outcomes for retail traders. Other venues have offered rebates on fees or other incentives to encourage retail business.

With both brokers and venues seeking to encourage retail trading, this increasingly competitive environment is further driving market fragmentation.

The impacts of market fragmentation for brokers

Fragmentation can bring benefits to the market. New venues can drive innovation and service needs that traditional exchanges don’t. For example, retail-focused trading facilities can help to expand market participation. However, fragmentation also brings challenges for market efficiency. It can be hard to find liquidity when orders spread across a multitude of venues – a particular challenge for institutions that handle large volumes. Having to manage such orders across a range of venues creates complexity and adds to operational overheads.

Regulatory standards around price discovery and best execution rely on major exchanges being effective price benchmarks. As less business is done on such exchanges, it becomes harder to establish what the best price is. Regulators can try to counteract this through efforts like the consolidated tape, or NBBO, but market fragmentation makes this inherently more difficult. Some of the regulatory burdens created by fragmentation also fall on brokers. Firms find themselves needing to source data from more venues than ever, to satisfy best execution requirements.

Market fragmentation contributes to a difficult environment for brokers. Retail-focused firms face cost pressures from the expectation of zero commissions. The need to work across multiple venues to find liquidity increases operational costs, while also increasing regulatory overheads. Faced with these pressures, broker firms are looking for solutions.

Trade tech solutions

For brokers of all kinds, technology is key to navigating fragmented markets. Access to the full variety of available venues is crucial, but can create operational overheads. For example, having to normalize market data from many different venues can be time-consuming and technically challenging. Integrating market access and data into wider trading solutions can help streamline this process. For trading itself, automation is key to addressing the operational burden of finding liquidity. Custom strategies that manage volume across multiple venues can help to mitigate the opportunity cost of missing out on liquidity away from the main exchanges. They can also help to reduce the complexity and manual work involved in managing orders in multiple venues. The ability to structure your orders across venues can help to deliver better execution outcomes, despite a fragmented liquidity environment.

ION Markets is working to help our customers navigate this fragmented landscape with our Fidessa Spotlight solution. This empowers users to create complex automated trading strategies with a high degree of control over which venues to target and how to execute. An intuitive user interface makes it straightforward to create and deploy new strategies, allowing for an agile approach.

The trends driving market fragmentation are deeply rooted. In both Europe and North America, a diverse range of trading venues are here to stay, and market participants must confront the challenges that this brings. Trade tech solutions and trusted partners are key to navigating this new landscape.