Alexander Neil, Head of Equity and Derivatives Trading at EFG Bank examines the regulatory changes facing dark pools, and the consequences for the buy-side.
As part of the European Commission’s review of the equity trading landscape, a proposal has been made to impose artificial caps on the amount of trades done against the Reference Price Waiver that was introduced in 2007 (otherwise known as caps on Dark Pool trading), whilst simultaneously fine-tuning the RPW to allow only mid-point executions. At the same time, the Commission is aiming to introduce higher regulatory supervision on Broker Crossing Networks (including those BCNs that operate Dark Pool books) by asking them to register as Multilateral Trading Facilities (MTFs). Whilst transparency remains of the utmost importance, its blanket application across all cases and asset classes is not the way to go; a specific concern is that the Dark Pool limits may have a detrimental effect on Equity trading and will end up raising the implicit costs of investing in Europe. Instead of dictating how and where orders are traded, I believe MiFID II presents the opportunity to build upon and, indeed, ‘clean up’ the existing market structure in order to maintain choice of execution venue and order handling, rather than to introduce further complexity.
Lit/Dark Equilibrium already found?
First of all, the proposals to cap Dark Pool volume appear to have been set at a seemingly arbitrary level of 4 per cent on any given venue and 8 per cent across Europe. Although there is a genuine lack of data on the subject, the latest figures seem to suggest that Dark Pool trades represent roughly 11 per cent of the European landscape (and makes up only a small part of overall OTC volume…which also includes give up trade reports, delayed block trade reports, ‘administrative’ trade reports, etc). Dark pool volume has indeed grown over the years, and is now made up of roughly half Exchange or MTF-operated pools and half broker-operated pools. Admittedly, the original mid-point crossing rule has largely been bypassed, but many investors still prefer a Dark Pool print thanks to the pre-trade protection it offers. Notwithstanding this, the growth in Dark Pool volume, and even venues, seems to have stopped. This would suggest that, given European trading rules, the market itself seems to have found a natural equilibrium of Dark Pool volume vs Lit . The sell-side may well have offered access to these venues, but it is those of us on the buy-side who continue to choose to route there, both on price-improvement and marketimpact grounds. Neither of these two trading criteria can be seen as working against transparent markets, therefore, does the EC need to intervene at all to limit Dark Pool volume?
The much-awaited new OTF category will not now be available to BCNs and, thus, they will have to register as openmodel MTFs. Besides the fact that it was thanks to MiFID I that these were created, it also seems counterintuitive, as broker-operated Dark Pools offer the ability to exclude certain toxic volume factions. There is a risk that remaining dark pool quality ends up suffering (throwing the BCN baby out with the dark pool water). Surely, we must maintain the choice of working in both order books in parallel, ensuring the best possible trading outcome.
A Dark Pool by any other name
The proposal to limit dark pool volume could almost be seen as an attempt to stem the very competition that MiFID I originally set out to promote. The aim of the proposal is ostensibly to make markets more transparent, and clearly any reference to the word ‘dark’, was always going to come under scrutiny (in fact, a rebranding exercise might well have gone a long way in calming fears!). If lawmakers genuinely believed that dark pool trades were detrimental to price discovery and the overall investment process, they would have banned them altogether. What conclusion are we to draw from this when midpoint/price improvement is recognized as beneficial, but only in small amounts and only for investors with the most advanced Algo’s? Moreover, since in any given trading day there will only be so many dark pool prints available, only the most technologically advanced or wellconnected investors will be able to get in first, resulting in a daily race to fill the quota. Several brokers that I have spoken to have suggested that a gradual lifting of minimum trade sizes could ensure that only the most ‘deserving’ trades get filled on dark pools. My concern with this solution would be that smaller sized trades (i.e. smaller investors) will not be eligible for mid-point price improvement. Sometimes it’s the 10bps+ price improvement that’s attractive; in other cases (illiquid stocks), its containing signalling risk.
Keeping options open
Let’s not forget that Dark Pool trading came at a perfect time for the industry, where the ability to contain signalling of trading intentions was made more difficult by a perfect storm of an overall drop in volume; buy-side cost pressure; sell-side services being reduced due to drop in revenues and a drop in average trade size owing to fragmentation. It made sense to route orders to dark venues as the most cost-effective way of trading, and continues to do so.
What seems strange to me is that despite a consultation process with the buy-side, and despite many buy-side interest groups widely calling for Dark Pools to be kept in place in their current form, Brussels seems to be intent on strongly encouraging us all to bring our trades back onto the lit markets. Surely the buy-side has no ulterior motive in this debate other than achieving better overall execution for end clients. Thus, why not simply let us vote with our orders, and keep our options open.
New rules, but old questions remain unanswered:
The problem is that, even if the caps are implemented, there is still no proper ECT in place yet. The EC continues to take a light approach in galvanizing once and for all a global post-trade trail; surely it would have made more sense to get the CT in place first and then use it to make decisions on where to trade.
Helping the industry come together to contribute to a rich and reliable post-trade CT ,and creating uniform print flags across Lit and Dark venues, would have gone a long way to make European Equity Markets more transparent. Instead, my concern is that we are being distracted by a larger debate over which provider (Exchange; MTF; Broker) should have the upper hand.
Perhaps the EC could have taken a less prescriptive approach and mirrored the Australian or Canadian regulators: There a minimum price-improvement rule was introduced across existing market structure, and this eventually led to a drop in Dark Pool volume, whilst still leaving the buy-side several attractive routing options. As with any long-term and wide-sweeping legislation, there is the risk that by the time it becomes law, the issues and the goalposts may have moved: For example, Brussels is acting on dark pools now because they are worried that they have grown too much. But that growth has already subsided (or, at least, paused). Perhaps there isn’t any need to intervene on dark pool growth but, rather, simply to ensure that it is adding value to the investment process. It would appear more credible if lawmakers imposed a cap of say 30 or 40 per cent (which is the proportion of Dark trades in the US), but to try and cap it so close to the current level seems almost futile. Secondly, the most growth in Dark Pool volumes occurred after the financial crisis, at a time when volatility was very low. This is normally a time when traders are prepared to forgo immediate execution in an attempt to capture price improvement (less risk of prices moving away from you)… Volatility is unlikely to stay low for very much longer, and so it is entirely possible that dark pool volume will drop without regulatory intervention as investors become more willing to pay the spreads on the lit books.
It is also a shame to think that, just as the European buy-side is coming to grips with how and when to use Dark Pools (which, indeed, we now widely consider complimentary to the lit venues), the regulator may well change the rules and limit our choices. I don’t know a single buy-side firm or investor who views the growth of Dark Pool trading as detrimental to their execution quality.
Will volume really get ‘lighter’, or will OTC grow?
I don’t think that volume will migrate overnight to the lit book as intended, but, rather, there is a risk that overall OTC volume actually ends up growing as investors elect to go back to bilateral Phone block trading and the trades are reported back to the exchange with a considerable delay. Surely, this cannot be preferable to electronic dark pool trading, where at least the trade reporting element is automated, and the buy-side has greater control over the order. My other concern is that if the EC mandates full use of the LIS waiver (already in place, but often supplanted by the RPW), overall volume quality will suffer, as traders may elect to let orders build up on their blotters until they have a large order and then work it in the dark pool, thus harming lit order book quality. Neither one of these outcomes feels like a better choice than that on offer today.
An even worse outcome could be that we see volume migrate to venues domiciled outside of the scope of the regulation. This eventuality could truly lead to a lack of transparency and accountability in our domestic trading.
If we have to allocate trades more selectively, our trading behaviour will adapt, but we’ll be losing the flexibility of simply parking a large chunk in the dark pool, safe in the knowledge that we can work on the lit whilst also not missing a crossing opportunity. Whilst working a chunky order on a Swiss midcap for example, if suddenly I can’t do that, I’m going to have to dedicate all my time to making sure that the market doesn’t figure out my full size, which may well include phoning a few trusted brokers to try and find natural blocks. This doesn’t seem like the most efficient use of a buy-side desk, and it’s something that we could be doing with our own OMS.
Maintaining buy-side choice
Ultimately, the new rules should be there to promote greater transparency and greater competition (wasn’t that what the original rules set out to do in 2007?) but, inadvertently, they might limit buy-side choices. Lawmakers should not forget that the buy-side works on behalf of the investing public, not against them, and that any rules that explicitly limit our trading choices could raise the implicit costs of investing. The argument that retail investors are unfairly treated in the modern market structure seems to run counter to the reality that most of the investing public are already represented by pension funds and asset managers. The choice to route orders to a dark pool should and must always be taken by the buy-side only, and I believe most investors are grateful for the opportunity to do so.