Gianluca Minieri, Global Head of Trading at Pioneer Investments examines reform in Europe and what the buy-side need.
The role of policy makers and regulators when dealing with financial markets should, in theory, be that of opposing speculation and short-term strategies and favouring long-term investments in the economy. They have the objective of creating a financial system that eventually serves the needs of those ultimately supplying or consuming capital, the real economy and the society as a whole.
It was with this principle in mind that MiFID I was introduced in 2007. The overarching objective of the original text was to lay down the foundation for a comprehensive, single regulatory framework capable of opening up European financial markets while ensuring significant levels of protection for end investors. The main belief on which MiFID I was based was that the European economy was getting insufficient funding from the financial markets and that one of the main factors was the high costs of transaction charged by trading venues. According to this theory, such high transaction costs were impeding the development of a secondary market, which, in turn, was detrimental to market liquidity. Based on the above considerations, I think we make no mistake if we say that the main target of MiFID I was to bring down the cost of transactions for investors and secondly, to facilitate the creation of a large secondary market which could eventually enhance liquidity. The tool that was agreed to address these issues was to promote competition amongst trading venues.
Despite some success in increasing competition, MiFID I could not keep the pace with the rapid developments in financial markets, trading systems and execution technologies and soon started to generate a number of major side-effects.
Liquidity was certainly the main one. MiFID I failed in terms of enhancing the level of liquidity in lit markets and had instead a devastating effect on it. It has increased fragmentation of liquidity across more trading venues, which made it more difficult for the buy-side to understand where the liquidity is. Where before there was a single provider of liquidity, now we see a proliferation of alternative venues, both lit and dark. Moreover, fragmentation of execution venues led to smaller transactions being traded with the aim of reducing market impact. Across all lit and dark venues, average trading sizes have reduced dramatically, roughly by two-thirds since its introduction. Now, because liquidity pools are smaller, the size at which the market is impacted went down as well, making it more difficult to execute large orders.
The concern to reduce market impact stimulated the use of algo trading specialising in slice and dice strategies. But because structured algos trade in a predictable fashion, it became easy for some High Frequency Trading (HFT) firms to create predatory strategies that watch for these footprints. Hence, instead of minimising market impact, MiFID I led to a growth of HFT, which constantly monitors orders seeking to take short term advantages by scalping them.
“The introduction of a single consolidated tape in Europe is of paramount importance to deliver best execution to our clients and enhance the level of transparency in the price formation…”
The review of MiFID I was therefore an opportunity. An opportunity to learn from the mistakes and, counter-effects brought by MiFID I and restore truth in Europe’s financial markets by encouraging a fair price formation process and efficient capital allocation. Usually the normal approach in a legislation review provides for an open debate with all stakeholders, which in turn provides policy-makers with comments, feedback, analysis, evidence and argument through lobbying. This was not the case in the current regulation reform approval process that soon become highly politicised and where many member countries and MEPs often took a philosophical approach on certain topics. Trading too much is always bad while transparency is always good. Competition is always good while dark trading is always bad.
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As a buy-side community, we have tried to be as proactive as possible along this process. We have made many trips to Brussels to meet legislators and policy-makers. We have presented analysis, studies and data. During these meeting, attended also by many buy-side firms, we have realised how little we, as buy-side, were conflicted on most issues. Our shared concern was to ensure that we do not lose the capacity to invest money efficiently for our clients. With this in mind, the key message that we brought to European regulators was that we all wanted to keep the interests of long-term investors at the centre of the discussion. Three topics have in particular been highlighted as our main concerns.
First concern: fast tracking introduction of a European consolidated tape (CT)
We think that the fragmentation introduced by MiFID I will not be resolved by the MiFID II proposal. On the contrary, we think that MiFID II will introduce further fragmentation. The introduction of a single consolidated tape in Europe is of paramount importance to deliver best execution to our clients and enhance the level of transparency in the price formation process and we are frustrated to realise that after so many talks this topic fell again into the background. Best execution today is difficult to monitor because of the lack of good quality post trade data. The current text proposed is too vague and weak to succeed. In our view, any solution is good as far as it is mandated, reasonably priced and potential conflict of interests are properly addressed. Conflicts of interest will arise in any case where a CT provider is also a market maker or operates trading venues. CT providers will in fact have privileged access to trading data. Hence, it is of critical importance that they are unquestionably perceived to be impartial, otherwise no market operators will allow them to get access to such information.
Second concern: Maintaining the use of the “reference price waiver”
Waivers are a legitimate way for large investors like us to manage their trades without undue disadvantages. Before imposing any arbitrary volume limits, regulators should find a mechanism to monitor markets, gather data and better assess the dynamic of the price formation process. In our view, a single consolidated tape would provide such mechanism because it would allow assessing the volume of trading that flows through the waiver.
Instead of imposing more restrictions, regulators should therefore make it easier for all types of trading data to get included onto consolidated tapes and enable them to become part of the price formation process.
“When we trade in the dark, we feel our investors are better protected. We have also explained that we rely on Matched Principal Trading to provide anonymity to our clients’ orders and to ensure that we do not trade with an unwanted or unregulated counterparty.”
Until we have a genuine consolidated tape and investors are adequately protected in terms of good quality market information, we will need the protection offered by the reference price waiver. Long term value investors, in fact, are concerned that orders of their clients will be unduly exposed to those market players whose principal activity is to exploit short term movements in markets, resulting in a permanent transfer of value from long term investors to short term liquidity providers. That’s why I also believe that RPW should be allowed for trading on OTFs.
Third concern: Ensuring the new OTF category is meaningful for investors, by allowing the use of Matched Principal
Several analyses show that the cost of trading on the primary exchanges can be more expensive than on dark pools, mainly because in the dark you are not paying the spreads. Moreover, market impact can be significantly lower versus trading in lit market, enabling trades to be carried out in large sizes. Large asset managers represent the interest of a wide variety of clients, hence they want to build their positions in blocks and with the appropriate level of confidentiality to protect investors. If a large trade is spotted entering the market, our orders might be subject to abuse by HFT firms. We definitely don’t want to deal with these firms that are making it fundamentally more difficult for institutional long-term investors to find liquidity at fair prices. When we trade in the dark, we feel our investors are better protected. We have also explained that we rely on Matched Principal Trading to provide anonymity to our clients’ orders and to ensure that we do not trade with an unwanted or unregulated counterparty. Without Matched Principal, the OTF category would be of no use to us and to our investors for any asset class. We have also highlighted that OTFs should be used for all asset classes, including equities. We understand that excluding equities from OTFs is a move designed to push more equity trading back onto stock exchanges, but our concern is that the latter might suppress rather than encouraging liquidity. Prohibiting interacting with existing client orders in its own OTF will worsen quality execution especially for less liquid instruments. In our view, deployment of own capital should be allowed where the client has consented to it and any conflict of interest should be addressed at regulation level.
With the trilogue under way, negotiations are now in their final stage. However, considering how long the same process took for other directives to conclude, there might be still a long way to go before the legislation becomes law. With this in mind, we hope that policy-makers will give buy-side firms more chances to have their voices heard. It is imperative that this time policy makers take the time to understand how financial markets will be affected by their decision. In our view, the difficulty remains that the legislators’ approach is too concentrated in seeking a one-size-fits-all approach to a wide range of issues with different characteristics. My concern is that, once again, such approach might lead to unintended consequences for financial markets at the expenses of end investors and long-term savers, exactly those that the policy makers intended to protect in the first place.
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Disclaimer
This article was prepared by Gianluca Minieri in his personal capacity. The opinions expressed in this article are the author’s own and do not reflect necessarily the views of Pioneer Investments or others in the Pioneer Investments organisation.
Developing TCAs beyond equities
I wanted to devise an optimisation platform whereby we would be able to understand how algorithms performed under various circumstances. I was attempting to build a grid based on the performance of these broker algorithms so that when an order came in, we could look at the grid and determine which algorithm would be best suited for that particular order.
Dark pools update : Lynn Strongin Dodds
A ROSE BY ANY OTHER NAME…?
Despite the trading community’s best efforts, the moniker dark pools has stuck. This is probably because “trading without revealing pre-trade price information” is not very catchy. One wonders though if the name was different whether regulators would be so intent on restricting activity.
The answer is probably yes and the arguments would have been the same. The proponents on both sides of the Atlantic argue that clients save money if their brokers do not have to pay exchange fees while institutional investors are going off-piste in order to avoid the market moving against them, or having to trade in small amounts with computer algorithms.
The public venues, on the other hand, feel hard done by because they have to comply with certain more stringent rules than their unlit counterparts. They also believe that the decreasing size of trades executed in dark pools, which can sometimes be only a couple of hundred shares, does not warrant some of the trading exemptions that dark pools receive.
In many ways it seems like a tempest in a teacup because dark pools are still a fraction of the market, but they are making their presence known. According to a new study by TABB Group, these venues only accounted for 11% of volume, but that is up from 2% three years ago while dark pools at alternative trading venues operated by companies such as BATS Chi-X Europe, Goldman Sachs Sigma X, UBS MTF, Turquoise and Instinet have enjoyed a market share rise to 5% from 3.2% in the last 12 months alone.
This explains why the regulators are moving in. The European Commission wants dark pools to offer price improvement — which would only allow trading in dark pools at prices better than those found on public markets. This is in addition to imposing volume caps on the amount of dark trading that can be done on a single venue and on an EU-wide level. This concept was first introduced in the Council’s draft of MiFID II while the European Parliament favours a pricing improvement rule.
The lines are being drawn in the sand with the exchanges backing the Commission’s latest proposals while the sellside worries that the proposals may limit investor choice which is one of the hallmarks of today’s high-tech and fragmented market structure. Perhaps the best course would be to follow the advice of Rebecca Healey, author of the TABB report,who said, “Regulation would achieve more by ‘cleaning up’ dark trading, clarifying the rules within an appropriate framework to maintain choice for the benefit of the underlying investor, rather than obliterating dark pools in their entirety.”
Lynn Strongin Dodds