Newly-analysed data suggests certain aspects of trading costs on the UK’s equity markets have fallen over the past three years – alongside those in peer markets in the US and Europe.
While we do not explicitly examine some costs such as the fees paid to brokers and the fees and rebates charged by individual trading venues, given these vary significantly per participant, we do look at several other components of trading costs, to provide insights into cost-effectiveness, competition and liquidity in the UK’s equity markets.
Low quoted spreads – the difference between the best bid and offer order prices on a venue – are one such component. The speed and likelihood of execution, market depth, and the impact of a trade on market prices are also important considerations. Taken as a whole, these can be referred to as a measure of 'execution quality'.
Improvements in execution quality
Our analysis focused on trading in FTSE 100 shares. We found that execution quality has improved since 2012 on the major UK equity trading venues – the London Stock Exchange (LSE), BATS Europe (which operates the Bats and Chi-X order books) and Turquoise.
Scrutiny of five different metrics – volume, quoted spreads, effective spreads, price impact and quoted depth – paints a broad picture of rising volumes, lower spreads and improved execution quality on the UK’s equity markets over this period1.
Overall, there has been a slight increase in the volume of equities traded on UK markets. Figure 1 shows the LSE has maintained its position as the market with the most volume traded in FTSE 100 shares despite an increase in competition from domestic rivals.
On the LSE, quoted spreads decreased from approximately 9.9 basis points (bps) on average in 2012 to 7.9bps on average last year. The decrease in quoted spreads is for the most part a market-wide trend (see Figure 2), perhaps due to greater competition for order flow and more integrated electronic markets, among other factors. All else being equal, lower spreads are good for market users and represent a decline in one of the explicit costs of trading.
How peer markets compare
We also compared equity trading on the LSE with peer markets in the US and France. For this analysis, our sample included (for comparison purposes) all equity securities with a market capitalisation greater than £5bn traded on the LSE, the New York Stock Exchange (NYSE) and Euronext Paris. These comprise a large subset of the stocks in the FTSE 100, Euronext 100 and S&P 500 indices.
A related metric, effective spreads2, factors in part of the trading costs of brokers at the point they demand liquidity (i.e. cross the spread) when executing trades. Figure 3 shows there has been a steady decline in effective spreads on the LSE between 2012 and 2015, totalling 0.69bps on average. This means a larger quantum of trades are now being executed closer to the mid-quote.
This should result in significantly lower trading costs for market users in aggregate. For example, using very simplistic assumptions3 for illustrative purposes, compared with 2012 levels this could translate into current cost savings of as much as £182,000 per trading day. Or £46m per year if replicated each trading day throughout the year, just for trading in FTSE 100 shares on the LSE.
This analysis does not attempt to assess whether (or to what extent) these savings are being distributed to end investors. Nor does it gauge whether some of the benefits from lower effective spreads have been gained by market intermediaries such as high-frequency trading firms4.
But trends in the UK appear to correspond to similar patterns elsewhere. Execution quality metrics for blue-chip equities traded on both Euronext Paris and the NYSE improved in unison over the past three years (see Figure 3).
One potential explanation for the lower effective spreads in Euronext 100 securities compared with FTSE 100 securities could be the lower tick sizes (i.e. the minimum incremental price movement allowed on a trading venue) prevalent on Euronext Paris. But we caution that we did not statistically analyse this. Tick sizes will be standardised across European trading venues from 2018 under new rules set out in MiFIDII.
We also looked at two other aspects of execution quality – price impact and quoted depth. Price impact quantifies the ability of a market to absorb the execution of large orders without the price moving significantly. In other words, it attempts to measure the ease with which a trader can buy or sell larger blocks of shares on markets. The lower the impact a large trade has on the price, the better the execution quality.
As Figure 4 shows, all three peer markets have recorded a drop in price impact between 2012 to 2015. Meanwhile, our analysis of quoted depth6 – in this case, the value of all orders placed at the best bid-ask spread – shows that the total supply of orders has been broadly stable in recent years on the NYSE and LSE, with a modest increase on Euronext Paris (see Figure 5).
There are a number of possible theories that might help explain these improvements in execution quality. Our analysis does not attempt to establish causation or to draw conclusions as to the drivers behind the improvement in execution quality.
Isolating a single factor would be difficult given the substantial changes over recent years. Changes to market structure, market participants, technology, interest rates and regulations for example, have all had their impact.
But greater competition for order flow – both from the trading venues and market participants – has certainly played a significant role in the changes over the past decade.