New Research: Understanding Price Formation and Venue Contributions in European Markets
Plato Partnership has released the second report in a two-part academic series examining order book quality and price formation across three key European markets. This research, commissioned under Plato's MI3 academic initiative, aims to provide open-access insights for all market participants.
The Importance of Price Formation
Price formation is the critical process by which asset prices are determined in financial markets. It occurs as market participants, including traders and liquidity providers, respond to various information sources and execute trades that reflect their perceptions of an asset's value.
In Europe, price formation takes place across multiple "lit" venues - public trading platforms that display orders in the order book. Key players in this landscape include national exchanges such as the London Stock Exchange (LSE), Euronext Paris, and Xetra in Germany, alongside prominent pan-European venues like Aquis, Cboe, and Turquoise.
Research Objectives and Methodology
The study's primary goal was to assess how these various venues contribute to price formation by evaluating three key aspects:
Their presence at the European Best Bid and Offer (EBBO), representing the best available prices for buying or selling an asset across different venues.
The frequency with which they improve these prices, known as EBBO Setting.
Their role in price discovery, or the extent to which they contribute to determining the true value of an asset.
Key Findings
EBBO Presence and Price Setting
EBBO Presence, which measures how often a venue offers the best bid or offer price across the market, serves as an indicator of a venue's competitiveness and reliability in providing optimal prices.
In France, Germany, and the UK, national exchanges and Cboe consistently dominated EBBO Presence. Notably, Cboe maintained the EBBO for approximately 88-93% of the trading day, often outperforming national exchanges.
In Germany, Xetra and Cboe demonstrated nearly identical EBBO Presence at 89%. In the UK, Cboe slightly outperformed the LSE (88.4% vs 86.1%), a statistically significant but economically modest difference.
EBBO Setting, the ability to establish new EBBO prices, is perhaps even more critical for price formation. Venues that frequently set new prices drive market efficiency and help align prices with an asset's underlying value.
In France, Euronext excelled, setting a new EBBO 60% of the time, while Cboe followed at 19%.
In Germany, Aquis outperformed both Cboe and Xetra, setting the EBBO 36% of the time, despite its lower overall EBBO Presence.
The UK saw the London Stock Exchange dominate EBBO Setting, responsible for 42% of price improvements, significantly surpassing Cboe and Aquis.
Price Discovery Contributions
The research employed the Hasbrouck Information Share (IS) method to quantify each venue's contribution to price discovery, evaluating how much each venue contributes to uncovering an asset's "true" price.
National exchanges like Euronext and the London Stock Exchange played dominant roles in price discovery. In France, Euronext accounted for 56% of price discovery, compared to Cboe's 36%.
In the UK, the LSE led with 51% of the contribution to price discovery, with Cboe at 40%. Germany saw Xetra contribute 58% to price discovery, while Cboe was responsible for 35%.
Notably, while Aquis had a relatively low contribution to price discovery via trades, its role became significantly more prominent when measured through mid-quotes. In Germany, for instance, Aquis accounted for 21% of price discovery when mid-quotes were considered.
The Consolidated Tape Debate
The findings of this research also contribute valuable insights to the ongoing discussion about implementing a consolidated tape in European markets. A consolidated tape would provide a single, unified view of trading data across all venues, potentially enhancing transparency and price discovery.
The study's results highlight the complex interplay between different venues in the price formation process, suggesting that a well-designed consolidated tape could:
Improve market participants' ability to identify the best available prices across all venues.
Enhance the visibility of contributions from smaller or specialised venues that play crucial roles in price discovery.
Provide a more comprehensive view of market liquidity and depth, potentially leading to more informed trading decisions.
However, the research also underscores the need for careful consideration in the design and implementation of a consolidated tape. The varying contributions of different venues to EBBO presence, price setting, and price discovery suggest that a one-size-fits-all approach may not fully capture the nuances of the European market structure.
Implications for Market Participants and Regulators
The research findings have several important implications:
For Traders:
Understanding which venues contribute most to price setting and discovery can inform more effective trading strategies, particularly in markets where participants may not have access to all venues.
Traders might consider routing orders through venues more active in price discovery, depending on their execution quality objectives.
For Regulators:
The findings underscore the importance of recognising venues not only for trade volume but also for their qualitative contribution to price discovery. Venues like Aquis, which play a subtle but important role, could be undervalued if only trade volume is considered.
Conclusion
The European equity trading landscape continues to evolve, with price formation emerging as a multi-venue process where both national exchanges and pan-European platforms play significant roles. While national exchanges like Euronext, Xetra, and the London Stock Exchange remain pivotal, pan-European venues such as Cboe and Aquis are increasingly important in setting new prices and contributing to price discovery.
This research provides valuable insights into the complex dynamics of price formation in European markets, offering a foundation for more informed decision-making by traders, venues, and regulators alike.
For a comprehensive analysis of the methodologies and detailed findings, please refer to the full paper available below: