Built for purpose?

European regulators are determined to reduce certain types of off-exchange trading activity via MiFID II but the resulting reduction of execution options could reduce the buy-side's willingness to trade.

What are the regulatory measures that could potentially decrease the level of choice in dark trading in Europe? 

Every time the review of MiFID takes another step in the European regulatory process, the future of dark pools operated by brokers looks bleaker.

Broker crossing networks initially emerged from a regulatory loophole in MiFID that allowed brokers to establish dark pools under the guise of OTC trading.

In an effort to bring BCNs under a clearer regulatory framework, the European Commission proposed the organised trading facility (OTF) a new category of trading venue proposed in its MiFID II draft that would encompass BCNs.

Initially, the OTF regime would have enabled brokers to operate their crossing networks with discretion on access and matching.

But MEPs are vehemently opposed the OTF regime for equities and have voted in their version of MiFID II to only permit the new venue category for instruments that will migrate onto exchange as part of OTC derivatives reforms.

A draft OTF proposal by the Council of the European Union – which must also propose amendments to the Commission text before a final version of MiFID II is adopted – also appears to be heading in the same direction.

Moreover, in an effort to improve price formation and reduce the amount of trading done away from public markets generally, the MEPs’ version of MiFID II states, “it is appropriate to limit the circumstances in which OTC trading can be carried out outside a systematic internaliser”.

What will these changes mean for users of broker crossing networks (BCNs) and how much liquidity is at stake? 

BCNs will have to reregister as multilateral trading facilities (MTFs) or systematic internalisers. This is likely to decrease BCNs’ attractiveness for buy-side traders because MTF status will take away the discretionary elements BCNs currently enjoy.

This means, for example, brokers would no longer be able to guarantee that an institutional-sized order in their BCN will not trade against HFT flow or other types of order flow a buy-side client wants to avoid.

The proportion of dark liquidity in Europe is growing, as is the amount of trading done in BCNs. According to data from Thomson Reuters, total European dark pool trading in September 2011 accounted for 4.87% of order book trading – 47.5% of which was transacted in BCNs. Last month, dark trading was 8.08%, with BCNs making up 51.8% of the total.

So just over 4% of liquidity is at stake. Surely European buy-side traders can live with that? 

It’s not all about the hard numbers though.

A lack of diversity when it comes to choosing how to execute trades – through a lack of BCNs and a restriction in OTC trading – could lead to a reluctance among buy-side firms to execute sensitive trades. It is entirely conceivable that the trading desk could well advise a portfolio manager not to trade in or out of a position because there just aren’t enough options for controlling market impact.

With a market structure in Europe that is becoming increasingly characterised by small order sizes, high-frequency trading and fragmented liquidity, a further reduction in the options available for long-only asset managers that want to execute in institutional size could have unintended cost consequences that end up hurting the end-investor.

Institutional investment activity is low enough as it is. Do we really want to give PMs another reason to stay out of the market?

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