Buy-side rejects changes to dark trading and SIs under MiFID II review

Initial responses to the MiFID II review consultation reveal that asset managers are keen for a consolidated tape before any major changes to the rules are implemented.

Asset managers have largely rejected huge changes to dark trading and systematic internalisers (SIs) under the MiFID II review, instead urging the EU regulator to establish a consolidated tape.

Responses to the MiFID II review consultation revealed that the buy-side is not in favour of the proposed modifications, which include the removal of the SIs as an execution venue for the share trading obligation and the option to eliminate the double volume caps (DVCs) for dark trading.

Many asset management respondents took the opportunity in their replies to the consultation to question the logic behind the DVCs, which have been a controversial issue since before they were implemented and subsequently.

“It is important to ask more fundamental questions about the effectiveness of the DVC before making incremental changes to the regime,” BlackRock said in its recently published response. “We believe that a more focused SI regime, a consolidated tape, and an EBBO are more effective tools to strengthen transparency and price discovery.

“Concerns that ‘dark’ venues detract from transparency and price formation would be best addressed by having a real-time tape of record that consolidates the information from all venues operating in the marketplace – ‘dark’ or otherwise. The same is true for pre-trade transparency, which is best addressed by developing an EBBO (European Best Bid and Offer).”

The DVCs were introduced in March 2018, following an initial delay to implementation, and have heavily affected trading volumes in dark pools in Europe. They trigger bans on dark trading when a transaction accounts for 4% of the total activity on a single dark venue, or 8% of total trading EU market-wide. 

Dark trading has steadily increased since the first set of DVCs expired in September 2018, despite early and dramatic declines following the introduction of MiFID II. The European Securities and Markets Authority (ESMA) stated in its MiFID II review consultation that the DVCs have had positive, but limited effects on market liquidity since they were implemented, and these benefits need to be balanced against the complexity of the DVC system.

Upon acknowledging that MiFID II had failed in its overarching objective to increase transparency, ESMA put forward various proposed modifications to the DVCs in its MiFID II review consultation, published in February, including extending the scope of the system, adjusting waivers or removing the DVCs completely in favour of another method to restrict dark trading.

Market participants have generally criticised the move by regulators in Europe to curb dark trading, which allows for minimal market impact and in some cases can provide the best price for clients. Some have argued the volume caps are arbitrary and not based on concrete analysis, while others have previously described them as a political compromise.

“One would ask for evidence of the ‘success’ of the DVC’s before we consider extending it,” said Janus Henderson’s response, penned by head of EMEA equity trading, Richard Worrell. “What was the rationale for the 4% and 8% levels selected originally and what evidence do we have that extending them would help investors? Have we seen greater depth to order books since the DVC’s were introduced for example? The basis of much of this paper is that the DVC’s haven’t succeeded in what ESMA seemingly wanted, so continuing to use them let alone extending them without evidence seems slightly mystifying

“We’re not convinced limiting dark trading is the right answer. Venues which offer price improvement, particular midpoint, should be encouraged as they help save investors’ money. When we assess the market, we would note lit venues, particularly the national primary exchanges, do still have the largest market share in each country so there is no cause for alarm.”

Hedge funds, it seems, agree with asset managers in the view that regulatory attempts to restrict dark trading are largely misplaced. The Alternative Investment Management Association (AIMA) rejected any radical changes to the DVCs, highlighting that huge volumes are executed on lit trading venues, but certain transactions need to be executed through dark venues.

“The fact that some transactions continue to be executed in a manner that is not pre-trade transparent is not an indication that the MiFID II transparency framework is inadequate, but rather that the nature of those transactions is such that it is not necessarily feasible or beneficial from a client/investor perspective to execute them in a lit trading environment,” AIMA said.

“We would caution against radical changes to the existing DVC given the potential to destabilise markets and given the significant resources that have already been expended by industry to operationalise the MiFID II requirements.”

The review from ESMA also targeted another controversial consequence of MiFID II – the SI. The SI regime requires investment firms to assess whether they are SIs for various assets on a quarterly basis, based on data from the prior six months of activity. If firms exceed thresholds from the calculations, they are considered an SI under MiFID II and have to fulfil SI obligations.

SIs could see some far-reaching changes from the review of MiFID II, with ESMA going so far as to outright ask market participants if they think the execution venues should be banned under the share trading obligation (STO). Concerns have long-been voiced that activity traded on SIs is not transparent enough, and the re-emergence of SIs under MiFID II has caused fragmentation.

“We do not support this at all,” said Baillie Gifford’s response, authored by Adam Conn, head of trading. “In our opinion it is essential investors maintain the ability to make in-formed decisions where they choose to trade. SI’s perform a role in providing liquidity, through the provision of risk capital or crossing of natural blocks between a buyer and seller.”

Asset managers overall largely rejected the proposal to eliminate SIs as an eligible execution under the STO, with many echoing Conn and pointing out to the regulator that SIs are a crucial part of the trading and liquidity landscape.

“We strongly oppose the removal of SIs as eligible execution venues for the purpose of the STO,” BlackRock said. “Systematic Internalisers play a crucial role of providing principal liquidity for large trade sizes. This is vital for investors both in calm and in disrupted markets. For that reason, it is essential to safeguard SIs.

“We understand that there is concern around the role that SIs play in the market ecosystem and questions around transparency. These are best addressed by strengthening the SI’s ability to provide meaningful principal liquidity. Further, a consolidated tape and EBBO can further contribute to better transparency of European markets.”

Efforts to develop a consolidated tape in Europe have been thwarted in the past due to concerns around the high costs of developing a tape in a restrictive regulatory environment with a lack of clear commercial benefits, despite widespread pleas from participants in both equities and non-equities. MiFID II laid out requirements for voluntarily consolidated tape providers, but it did not mandate the establishment of a consolidated tape that firms would have to submit transaction data to, as is the case in the US.

“Rather than focus on shifting trading back to lit primary markets to the detriment of the end investor, improved standardisation of data, via a consolidated tape, would enable regulators to robustly monitor and supervise markets, yet still enable best execution to continue as it should, lowering the cost of investment in the process. That is how investor confidence in European Capital markets can best be restored,” Conn added in Baillie Gifford’s response.

Following a consultation on the launch of a consolidated tape in July, ESMA stated that despite the challenges, it will recommend the establishment of a consolidated tape for European equities to the European Commission. The deadline for responses to the MiFID II review consultation have also been extended due to the coronavirus pandemic until 18 May.

“A successfully governed European consolidated tape would be transformative for markets and for investors,” BlackRock added. “It would bring clear benefits; increasing transparency and strengthening best execution, while simultaneously improving competitiveness of European capital markets and contributing to the delivery of Capital Markets Union (CMU).”