RegTech Intelligence

Mind the cap: dark trading under MiFID II

JWG analysis.

With Australia and Canada having already adopted new rules to oversee trading within dark pools, it is now Europe’s turn to shed some light on this activity.

Considering that only about 9% of European equities were traded within dark pools in 2014 (in comparison to about 40% in the US), it may seem surprising that MiFID II is seeking a highly inflexible approach towards dark trading, predominantly through the introduction of controversial caps by 2017.

The problem is that the regulators do not trust this type of activity … and with seemingly good reason.  Earlier this year, UBS paid $14 million to settle a Securities and Exchange Commission complaint that the firm had created an order type for its dark pool that gave advantages to high-frequency traders over other market participants.

Are dark pools as sinister as they sound?

Through negative association, many may assume that the term ‘dark pool’ suggests some form of illicit activity.  However, a dark pool simply describes a network that allows traders to buy or sell large orders without running the risk of other traders taking advantage of the order.

Within this network, pre-trade prices are not visible to anyone and are only revealed once the trade is done.  The purpose of this secrecy is to minimise market impact.  Not revealing quotes allows for more efficient trade executions, due to the reduced possibility of erratic price movements.

Three different types of dark pools are thought to be operating currently within the financial services industry. These include dark trading pools run by traditional exchanges, ones run by brokerages or banks and those run independently.  It has been argued that each of these hold the potential for market abuse due to a lack transparency.

What are the new rules prescribing?

The new regulations aim to limit the amount of trading that can be done in the dark.  The limits, also known as the “double-cap”, are set on a monthly basis and, as the name suggests, are set in two parts.

MiFID II will impose a cap of 4% of the total amount of a stock being traded on an individual platform within the EU on dark trade stocks, compared to the 8% cap for anonymous trading on stocks.  Exceeding these caps, means that firms will face a ban on trading the stock on any dark pool for six months.

Although the nature of the pools makes it hard to know when caps are hit, regulators are expecting greater clarity on this activity once EMIR provides supervisors with much needed data in 2016.

A survey carried out by the London Stock Exchange in April has suggested that almost all of the FTSE 100 stocks would exceed the threshold.  Similar research by Bats Chi-X Europe has found that the majority of blue-chip stocks would also be affected.

One virtue for firms in the industry is that the caps will not apply to trades that are deemed ‘large-in-scale’, although this figure differs for each stock depending on liquidity characteristics.  Many have suggested that concerned firms will just move as many trades as possible towards the exempted regime.

There are worries that these new rules will result in higher transaction costs due to firms having to carry out more small orders. And, as previously mentioned, this network hinges on secrecy, so shining a light on the activities may lead to dwindling liquidity.

How have firms reacted to the new rules?

The intention of the new rules may have been to force firms offering dark pools to restructure and open them up to more markets, but many firms affected by MiFID II have instead chosen to close down their dark pools and join consortia like Plato Partnership.

Plato Partnership, a consortium of asset managers and brokerage houses, is taking on existing trading venues that do not publish pre-trade price and volume information.  In other words, Plato Partnership is a trading utility for anonymous block trades.  It will be open to all market participants with the aim of “reducing trading costs, simplifying the market structure, creating deep liquidity opportunities and delivering an equal trading experience for all market participants”.  Plato Partnership has said that it will use the “revenue generated from its trading utility to commission academic research focusing on better trade execution and lowering execution costs”.

In a research paper from an asset manager’s perspective, Norges Bank Investment Management state there would ideally only be one dark pool.  This may help to explain why Plato Partnership has already been backed by a larger number of firms (Axa, Deutsche Asset and Wealth Management, Fidelity, J.P. Morgan Asset Management, Norges Bank Investment Management, Union, Barclays, Citi, Deutsche Bank, Goldman Sachs, Morgan Stanley and UBS).

On 24 July, the news broke that Plato Partnership had chosen the London Stock Exchange Group’s subsidiary, Turquoise (which already operates a so-called ‘dark pool’ venue for large block trades), as its preferred partner.  The news detailed an exclusive deal as the two companies announced that they were exploring a ‘commercial collaboration’.

The market is currently preparing for the new rules, considering its options and examining the ways in which it will be able to trade.

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