Proposals on dark pools and derivatives trading in the Council of the European Union’s latest draft of MiFID II have drawn criticism from the European Commission.
The latest Council draft of MiFID II proposes the reference price transparency waiver – a provision in MiFID I used by dark multilateral trading facilities (MTFs) to forego the publication of pre-trade quotes – should only be used for trades above €6,000. The European Parliament – which has already completed its version of MiFID – included the reference price waiver in its final text.
The waiver is used by the vast majority of European dark MTFs – including those operated by BATS Chi-X Europe, Turquoise and UBS – which collectively accounted for just over 4.5% of overall European trading last month, according to data from Thomson Reuters.
The Commission, which did not include the reference price waiver in its original draft of MiFID II, remains opposed to the reference price waiver, as part of a bid to limit dark trading, according to its response to the Council draft, seen by theTRADEnews.com.
“These waivers risk undermining the overall objective of the MiFID review in terms of transparency,” read the Commission’s response. “There is no justification to retain these waivers, as orders that have a market impact can benefit from the waiver for large in scale orders (LIS). Retaining these waivers would also allow dark pools to continue operating in the dark.”
The Commission also stated the €6,000 threshold was very low and that it has a “general concern” over fixing such a threshold in MiFID II’s high-level text. Typically, these types of thresholds are determined by the European Securities and Markets Authority, which is charged with formulating technical standards related to securities market regulation once European policymakers have agreed on a final legislative text.
Uncertainty over the reference price waiver has been greeted with mixed views by dark pool operators, with some believing the benefits of dark trading – to minimise market impact – have faded as lit and dark trade sizes have converged. According to analysis of December 2012 dark pool activity by Liquidmetrix, the lowest average trade size among dark MTFs was €5,555 for BATS Chi-X Europe’s CXE venue. By comparison, the average trade size on the London Stock Exchange’s UK market was €7,054 last month,
“While the minimum size threshold proposed by the Council may not be the most optimal solution, we believe that trading should only take place on a non-displayed basis if you can achieve an outcome that improves upon what you would get on a lit market,” said Per Lovén, head of international corporate strategy at Liquidnet, a block trading platform. “This may include price improvement, unique access to liquidity and/or minimisation of market impact. In this context, it’s not fully clear what benefit small-sized trades at bid/offer in a non-displayed environment would have on execution performance.”
Liquidnet uses the LIS waiver for around 70% of its trades and the reference price waiver for the remaining 30% that do not qualify.
A recent MiFID II position paper from BATS Chi-X Europe, which uses the reference price waiver for both the dark pools it operates, stated the inclusion of small orders in dark venues increases the fill rate for larger trades.
“The reference price waiver allows investors to trade blocks of securities while minimising market impact, and reducing the need to pay a risk premium to intermediaries for assuming the risk on their behalf,” read the paper. “The LIS waiver is not sufficient to facilitate this business as it is highly unlikely that there will be an equal and opposite large order to trade with, in the same security and at the same time. The inclusion of smaller orders makes it more likely that an execution will occur.”
Derivatives exemptions
The Commission also raised concerns with the Council’s proposal to exempt OTC derivatives transactions of over €100,000 from the obligation to trade on exchange-like venues.
With the European market infrastructure regulation (EMIR), MiFID II forms part of the European response to the G20’s mandate to reform OTC derivatives trading. MiFID II will include rules for when OTC derivatives should be traded on exchange-like platforms. EMIR includes an obligation to centrally clear swaps and report transactions to data repositories.
Part of the thinking behind the Council’s threshold relates to the need to converge with block trading rules for swaps under the Dodd-Frank Act, the US’ version of OTC derivatives reform.
However, the Commission notes US block trading rules exempt trades from pre-trade transparency, rather than the obligation to trade on a venue.
“If a similar exemption is indeed being contemplated in the US, the Commission considers that this is a serious issue to be taken up with the US authorities, rather than to engage in an international race to the bottom,” read the Commission’s response. “However our reading of US legislative developments in this regard is different. The large size transactions would be exempt from pre-trade transparency requirements but would still have to be executed pursuant to the swap execution facility rules (i.e. these transactions could not take place OTC).
“It should be noted that a threshold of such low value would exempt virtually the whole market from having to trade on venue. The Commission services consider the inclusion of such a low number would reflect the wrong intentions as to the share of trading which is to take place on electronic venues,” added the note.