Market Structure Trends Brazil and Abroad

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1 Market Structure Trends Brazil and Abroad Presented by Larry Tabb (Founder & CEO) ANCORD Sao Paulo, Brazil March 2015

2 Agenda Trading trends US/Europe 2 Competition Electronification HFT Institutional trading Brazil Local challenges New competition What to expect How to prepare How Brazil will be different Conclusion

3 NYSE had a physical floor with the specialist acting as a monopolist market maker NYSE Investors Broker Specialist Floor Brokers 3

4 NASDAQ employed a network of dealers/market makers to match buyers & sellers Investor Broker NASDAQ Broker Investor Broker Investor Investor Broker Broker 4 Investor

5 SEC Order Handling Rules and Reg ATS Changed Equity Trading Life SEC found NASDAQ market makers colluding on pricing In 1997 developed order handing rules mandating the development of electronic execution First execution platform was called SOES Small Order Execution System Enabled small investors to electronically interact with posted quotes Turned indicative quotes into actionable Island soon followed as first upstart ECN Soon there were 9 or 10 significant ECNs Consolidation has followed 5

6 Decimals is the second major market structure change that has radically changed equity trading From 16 price points to Less liquidity at any one point 1/16 1 Less expensive to jump bids Fractions 1/8 3/ More need for specialist to bridge liquidity 1/4 4 Less profitability for dealers Market structure change to agency model Decimals More expensive for large investors

7 Decimalization impact Because of ECNs order books are more available to see where liquidity breaks are Easier to jump in front of traders sitting on order book Tightened spreads Open order books & ECN access reduce desire to post limit order And limit orders posted are smaller Market makers model not profitable Dealers migrating to agency model Switch to agency model allows easier price comparison Need sophisticated tech to manage order book internally 7

8 In a macro sense this transition is about execution control from exchange to client Thin OMS Fat Exchange OMS Fat EMS EMS Exch 1 Exch 2 Single Exchange Model Exch 3 Matching Logic & Order Types ECN 1 ATS 1 8

9 Automated/Electronic trading has reduced the cost of execution both within markets and even for most institutions Source: ITG Source: Knight Source: Charles M. Jones PhD Columbia Business School What 9 do we know about high-frequency trading?

10 Most academic studies say that competition / HFT overall reduces spreads & lowers transaction costs Foresight Report: The Future of Computer Trading in Financial Markets (2012) Improved liquidity, lower transaction cost, and more efficient pricing Hagströmer, Björn and Norden (2012) - The Diversity of High Frequency Traders Market making and opportunistic HFT strategies mitigate intraday price volatility Hasbrouck, Saar "Low-- Latency Trading", May 2011 Low latency automated trading was associated with lower quoted and effective spreads, lower volatility and greater liquidity Angel,Harris &Spatt: "Equity trading in the 21st century", February 2010 Trading costs have declined, bid ask spreads narrowed and available liquidity has increased Chaboud, Hjalmarsson, Vega and Chiquoine Rise of the Machines: Algorithmic Trading in the Foreign Exchange Market, October 2009 Automated trades increased liquidity and may have lowered volatility Hendershott, Riordan Algorithmic Trading and Information, August 2009 Automated trades made prices more efficient and did not contribute to higher volatility 10

11 Across Europe effective spread has declined in 92% of 60 most liquid stocks (20 each in FTSE, DAX & CAC) Source: 11 TABB Group 9

12 Avg spreads came down as exchange competition was introduced across Europe Source: 12 TABB Group 10

13 Despite drop in volume, competition has kept pressure on effective spreads even during height of crisis Source: 13 TABB Group 11

14 Too much of a good thing 14

15 These regulations opened up a floodgate of competition. This is just the early stage competitors NYSE Instinet Brut NASDAQ DirectEdge Knight NASDAQ Island Arca Arca Instinet LavaFlow Citi Attain Redi Strike Brut TradeBook NextTrade Track BATS 15

16 US Market structure has spun out of control. Trading venues have proliferated. The US has 11 exchanges & 41 ATSs, but starting to consolidate Exchanges NYSE NYSE Arca NYSE Amex NASDAQ NASDAQ BX NASDAQ PSX BATS BZX BATS BYX DirectEdge EdgeA DirectEdge EdgeX CBSX CBSX / NSX CSX ATSs AQUA Barclays (3) Barclays DirectEx Credit Suisse CrossFinder ITG POSIT Credit Suisse Light Pool Cross Stream J.P. MORGAN SECURITIES LLC JEFFERIES EXECUTION SERVICES, INC. Morgan Stanley (MS Pool) Morgan Stanley (Trajectory Cross) PDQ Barclays LX Dealer Web Knight Link by KCG RiverCross BIDS Deutsche Bank SuperX LavaFlow ECN Pro Securities SpeedRoute BLOOMBERG TRADEBOOK LLC FOLIOFN INVESTMENTS, INC. LeveL State Street (Block Cross) Citadel Apogee Goldman Sachs Sigma X Liquidnet H2O UBS Citi Cross IEX Liquidnet Negotiated Weeden XE Citi LIQUIFI Instinet CBX Merrill Lynch (2) ConvergEx Group Millennium Instinet Crossing Merrill Lynch (MLXN) 16

17 But Brazil isn t the US 17

18 Brazil is a very significant and investable market. 6 th in terms of AuM, and 5 th in terms of number of funds Global Investment fund Industry 18 Source: ICI, Moodys

19 Equity investment opportunities are challenged top 10 stocks = 48%, top 5 derivatives = 97% 19

20 And IPO market is pretty much nonexistent with only one IPO in 2014 BRL IPOs US, UK, & EU vs. Brazil 2014 BRL BRL in Billions BRL BRL BRL BRL BRL Brazil US UK Euro Australia

21 Brazil trading cost are above peers 21

22 The cost of trading in Brazil is significantly higher than that of many smaller markets Cost of Trading (bps) & Distribution of Costs in each Financial Center 4X Expense vs USA 22 Source: CVM Brazil User 1 - Intermediary 1 User 2- Intermediary 2 User 3 - Intermediary 3 User 4-Intermediary 4

23 The exchange generated more net income than the Brazilian brokerage industry through 3 rd q H Q2014 9months 2014 ROE Independents (BRL 5,858,581) BRL 22,053,482 BRL 16,194, % Global Banks BRL 380,718,189 BRL 259,272,689 BRL 639,990, % Total industry BRL 374,859,608 BRL 281,326,171 BRL 656,185,779 Source: CDI dejaneiro Sept H Q2014 9months 2014 Total 2014 Bovespa Operating Income BRL 590,795,000 BRL 352,506,000 BRL 943,301,000 BRL 1,226,363,000 Operating Margin 62.0% 64.7% 63.0% 60.4% Source: company 1H Q2014 9months 2014 Total 2014 Bovespa Net Income BRL 506,438,000 BRL 238,693,000 BRL 745,131,000 BRL 977,914,000 Bovespa Net Margin 53.2% 43.8% 49.8% 48.1% Source: company 1H Q2014 9months 2014 Industry Income/Bovespa OI 63.5% 79.8% 69.6% Industry Income/Bovespa NI 74.0% 117.9% 88.1% Source: company Market Op Margin / Net Margin Market Op Margin / Net Margin 23 NASDAQ = 21% / 12% NYSE = 16% / 8% LSE = 29% / 15% Deutsche Boerse = 38% / 25% ICE = 44% / 15% JPX = 44% / 26% ASX = 67% / 47% Best parallel

24 Competition changes trading cost dynamics. Vertically integrated dominant platforms can shift cost to post trade Comparative Trading Cost (in bp) Trading/Post-Trade as a % of Total Cost Trading Post Trade USA % 50% Chi-X Europe % 86% Germany % 56% UK (LSE) % 55% Mexico % 91% Hong Kong % 55% Italy % 47% Australia Chi-X % 94% Australia ASX in % 89% Canada % 95% Australia ASX in % 85% Brazil (day trader fee) % 73% Brazil (standard fee) % 80% South Africa % 88% Poland % 23% Singapore % 83% Indonesia % 48% Spain % 27% Argentina % 0% Trading Cost Post-Trading Costs 0% 50% 100%

25 In a vertical model the Exchange, CCP and possibly the depository are affiliated Brokers Exchange CCP Depository Alternative Platforms Barriers Operational, Technological, and/or Cost 25

26 The US Equity Market is a horizontal model where there is a single CCP Brokers Exchanges Independent CCP Depository Alternative Platforms 26

27 In Europe and what is proposed in Brazil is a competitive CCP Brokers Exchanges CCP Depository Alternative Platform 27 CCP Depository

28 DMA volume on Bovespa is gradually increasing from 39% to 46% in Sept % DMA vs. Non-DMA Volumes (Bovespa) Monthly BM&F BOVESPA DMA percentage 90% 80% 70% 60% 50% 40% 30% 20% 39% % 10% 0% 28 Source ATB Brazil, TABB Group DMA Non-DMA

29 Increasing DMA will increase buy-side algo usage to implement strategies, capture spreads, and provide liquidity Estimated Buy Side Algorithm Usage in Brazil 29 Source ATB Brazil, TABB Group

30 As buy-side takes control and costs go down growth of low touch channels increases dramatically Historical US Buy Side Usage of Medium and Low Touch Channels 63% 68% 53% 31% 21% Source: TABB Group

When we look at the market, electronic trading revolves around this infrastructure & these processes Market Data Trade Generation Execution Strategy Direct Access / Aggregation Matching Transaction

31 When we look at the market, electronic trading revolves around this infrastructure & these processes Market Data Trade Generation Execution Strategy Direct Access / Aggregation Matching Transaction Cost Analysis Direct Feeds Black Black Boxes Boxes Algorithms DMA Analyzing data from different venues What to buy and sell - when How to buy and sell - where Internalization & Crossing Pre & Real Time TCA 31 Source: TABB Group Getting to the right venue Matching buyers & sellers Did you make the right decision?

32 What does this mean for Brazilian brokers? Opportunities Cost of execution & clearing will decline with added competition 32 Exchange Op margins should fall from 60% to 40% & Net Margin from 50% to 25% Ability to offer differentiated services Today all orders go to one place: future routing becomes factor in best execution A second market will increase resiliency Liquidity will increase as cost declines & new players come into the market Both market makers & investors (cost decline & greater market resiliency) Balance of power will begin to tip away from exchange Impacts Need to increase connectivity expense More technology (SOR, CEP, market data, TCA ) Different skills (more technical and analytical) will be needed However Brazil will never be as fragmented or complex as US or Europe Regulators do not want this type of market Market structure won t cure all market ills. But relief is needed & a new competitor will help

33 Conclusions Market competition is good Lower s cost, creates new opportunities, crates a more efficient market, spurs innovation Competition needs either open clearing or independent clearing to be successful Market competition does create complexities With multiple markets, more technology is needed Speed does become more important But increasingly technology is needed even in a unified market structure as technology is faster, cheaper, and more accurate than humans As markets become more electronic strategies change Blocks become fewer, algos become more prevalent But this lowers cost Also transfer s risk from sell-side to buy-side Now Brazil won t be like US 2 markets instead of 50, No dark pools Depth of book trade through Need to think about electronic trading as a series of technologies Data, market maker algos, buy-side algos, routers/access, electronic matching, and TCA 33

34 Market Structure Trends Brazil and Abroad Presented by Larry Tabb (Founder & CEO) ANCORD Sao Paulo, Brazil March 2015

The State of the U.S. Equity Markets

The State of the U.S. Equity Markets September 2017 Figure 1: Share of Trading Volume Exchange vs. Off-Exchange 1 Approximately 70% of U.S. trading volume takes place on U.S. stock exchanges. As Figure