Brokers may not smart route to LSE’s hidden order types

Sell-side institutions that direct client flow via smart order routers are unlikely to use the London Stock Exchange’s (LSE) proposed hidden or dark order types because of the restrictions imposed by MiFID’s large in scale (LIS) rules.
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Sell-side institutions that direct client flow via smart order routers are unlikely to use the London Stock Exchange’s (LSE) proposed hidden or dark order types because of the restrictions imposed by MiFID’s large in scale (LIS) rules.

The LSE will introduce hidden limit order types on its SETS electronic order book on 16 March. This will allow traders to interact with displayed and non-displayed liquidity on the LSE without displaying price or volume to other participants. The initiative is seen as particularly useful to market participants looking to execute large block trades with minimal market impact.

But to forego MIFID’s pre-trade transparency requirements – and therefore preserve the anonymity of dark functionality – the LSE has to comply with LIS restrictions. (Unlike dark pools, the LSE cannot use the alternative price reference waiver available under MiFID because it is a primary exchange.) LIS rules only permit hidden or dark orders if they are above minimum order sizes, based on the average daily turnover and market capitalisation of a stock, as defined by the Committee of European Securities Regulators.

This means that dark orders sent to multiple venues could fall below size levels required by regulators, if sliced too thinly.

“If there are several order books offering this service and you are using a smart order router (SOR) to post a hidden order, the order will be split up into smaller sizes before being distributed on multiple venues and will therefore no longer qualify for LIS requirements,” George Andreadis, head of AES liquidity strategy, Europe, Credit Suisse told “We would rarely rest orders on one venue alone because we don’t want to miss out on liquidity that can be found else where, so I’d question the usefulness of LIS orders when it comes to achieving best execution for our clients.”

The LSE maintains that the depth of liquidity available on the exchange will make dark order types attractive to a wide range of market participants. “The exchange provides the deepest liquidity for UK securities and we already receive a significant number of orders which are large enough to qualify for the LIS requirements,” said an LSE spokesperson. “We expect that firms will both post hidden orders on SETS and seek the price improvement opportunities which the presence of hidden orders may offer,” said an LSE spokesperson.

Market participants that are comfortable with resting orders on exchanges expect to make use of the LSE’s hidden order types. “Dark orders are an important part of our trading strategy,” said Toby Bayliss, head of algorithmic and program trading, Sanford C Bernstein, a US-owned broker. “They are an efficient way of concealing orders and limiting impact. Also, the pegged orders will allow us to reduce latency by using the exchange’s functionality for pegging, instead of re-entering orders which takes time to react to the market.”

Once the LSE completes its FIX 5.0 implementation this summer, it will add further dark order functionality, including pegged limit orders, which allows market participants to align their order with either the best bid, best offer or mid-price available on the market, and minimum execution size (MES), which protects firms against gaming by enabling them to stipulate a minimum order size against which their hidden orders can execute.

Anti-gaming protection such as MES is a key criterion when sending an LIS order to a single venue due to the signalling risk, Credit Suisse’s Andreadis added. “Without adequate protection, LIS orders can be pinged by smaller orders on the book resulting in poor execution quality for clients. You need to be a bit smarter when using hidden liquidity to trade large orders,” he said.

“We are active users of these order types on other venues but usage of the LSE’s hidden orders will be limited until MES is implemented, agreed Bayliss. “This will be a more of a constraint for less liquid stocks, but we will judge this on an order-by-order basis.”

The LSE said the introduction of hidden pegged order types and the ability to stipulate minimum execution size will give customers more tools to manage use of hidden orders. In Q2, the LSE is due to launch Baikal, a non-displayed multilateral trading facility which will handle hidden orders of any size and aggregate access to hidden orders in other liquidity pools, with anti-gaming controls and aggregated settlements.