Dark pools and the ‘misplaced pursuit of transparency’

As the saga that is Mifid II rumbles on, Hayley McDowell asks have regulators lost sight of the end goal – to protect investors?

On the whole, traders believe that Mifid II rules on dark pools will hinder dark trading when they come into force on 3 January 2018.

The rules were drawn up to enhance transparency, but market participants are concerned this quest for transparency has resulted in regulators losing sight of the end investor.

Among those with reservations is Rob Boardman, chief executive officer at ITG.

Speaking to the TradeTech Newspaper, he said there is a “confusion of objectives,” which requires further attention.

He explained: “The drive for transparency was born out of the G20 Pittsburgh Summit in the wake of the financial crisis – but dark trading didn’t have anything to with the crash

“Mifid II’s dark trading caps are the result of a misplaced pursuit for transparency and have lost sight of the interest of the main investor, which really should be at the heart of any regulation.”

It’s not just the dark trading caps that market participants are questioning. Technologists say the consequences of Mifid II are so difficult to predict that there are likely to be more “unintended outcomes.”

Michael Cooper, chief technology officer at BT Radianz, said: “The basis for Mifid II regulation of dark pools, assertions regarding impacts on price formation for instance, are open to debate…”

Cooper explained that if the ‘need’ for Mifid II regulations are open to debate, then the regulatory response still needs further probing. After all, if regulators don’t fully understand what they are trying to solve, how can they solve it?

Cap up

At last year’s TradeTech conference, the London Stock Exchange Group (LSEG) presented some revealing predictions on the likely impact of Mifid II’s dark pool caps.

Most noteworthy was the claim from Brian Schwieger, head of equities at the LSEG, that almost all shares quoted on the FTSE 100 would be affected and more than half of those stocks listed on the FTSE 250.

He explained: “Our analysis suggests that, among the FTSE 100, 28 names will be above the cap just based on use of the reference price waiver

“However, when we add in the negotiated trade waiver, all but one of the FTSE 100 will be unavailable to trade in the dark from January 2017, and among the FTSE 250 it is more than half.”

Of course, we have since learnt that the January 2017 deadline has moved. The European Commission confirmed in February an extension of the deadline. The extension was to “take account of the exceptional technical implementation challenges faced by regulators and market participants.”

What is interesting is that at last year’s conference, we learnt that the caps on dark trading were originally introduced as a political compromise.

It was Marcus Ferber, a special rapporteur for the European Parliament during Mifid II negotiations, who let the cat out of the bag on this one.

Speaking on a panel at last year’s event, he said: “in my personal opinion, the double cap will not function.”

And yet, in the face of so much resistance, regulators have pressed on with the rule changes, albeit making tweaks (and date changes) along the way.

ITG’s Rob Boardman reiterated Ferber’s comments a year on. He said that there are better ways to improve markets:

“The caps are a blunt instrument based on a crude understanding of dark trading. There are scenarios and valid trading strategies beyond large blocks where dark pools can give better execution that the lit exchanges.

“Ultimately, the dark trading caps represent a victory for the exchange lobby, not the investor.”

Some believe that the problems started with the introduction of Mifid I, which effectively “distorted the off-exchange market over the past couple of years”.

The publication of ‘Flash Boys’ by controversial author Michael Lewis demonised the world of high frequency trading and raised questions.

While Lewis succeeded in shining a light on dark pools and dark trading, the interpretation of the practice by the mainstream media was one-sided and distorted, according to many delegates attending this year’s conference.

Despite that, the regulatory activity seen over the past 12 months highlights that there were some abuses of the non-lit markets.

In February this year, Credit Suisse and Barclays settled investigations by US regulators into their dark pools by agreeing to pay a combined $154.3 million in fines.

Barclays and Credit Suisse both admitted to making false statements in connections with the marketing of their dark pools and other electronic trading services.

At the time of writing, the fines were among the biggest settlements relating to dark trading ever. Both financial institutions were accused of misleading investors.

According to the Securities and Exchange Commission (SEC), who investigated the accusations, two Credit Suisse alternative trading systems (ATS) failed to operate as advertised, and failed to comply with numerous regulatory requirements over a multi-year period.

Barclays admitted similar offences, overriding its surveillance tool and misleading its users about data feeds.

Director of the SEC’s enforcement division, Andrew Ceresney, said at the time of the settlements: “Dark pools have a significant role in today’s equity marketplace, and the firms that run these venues must ensure that they do not make mis-statements to subscribers about their material operations

“These largest-ever penalties imposed in SEC cases involving two of the largest ATSs show that firms pay a steep price when they mislead subscribers.”

The irony though, is that despite record settlements, increased regulatory attention and controversy surrounding dark trading, it is more popular than ever.

A report from the Association of Financial Markets in Europe (AFME), found that equity trades on European exchanges and MTFs were up 28.7% in 2015, compared to 2014.

Mark Pumfrey, head of EMEA at Liquidnet, says the scale of dark trading will increase following regulations.

He said: “… with the large-in-scale waiver, we expect to see dark trading sizes to increase.”

Pumfrey’s former colleague, Per Loven, poked holes in the way waivers are calculated during a panel discussion at last year’s TradeTech conference, saying “Large in scale should be more dynamic and related to ADV and ADT.

The waiver is intended to protect large orders from erratic price movements which could cause distortion. Although disputed as being too simplistic, ESMA views average daily turnover (ADT) as a reliable metric, which can be collected and processed in a simple way.

Loven added: “These measures are readily available and used by traders every day so we should be using them as a way to more accurately calculate the large in scale waiver based on how a stock is trading at any given time, rather than using fixed thresholds.”

Genuine debate

New initiatives were discussed at last year’s TradeTech conference, and one panel left industry experts in disagreement over trading blocks.

Mike Bellaro, global head of trading at Deutsche Bank Asset Management, suggested that initiatives like the Plato Partnership will bring about ‘old-school’ block trading.

Plato was founded by Deutsche Asset & Wealth Management together with Axa Investment Managers, Fidelity Worldwide Investment and JP Morgan Asset Management and others.

It aims to create a “non-profit” block trading network that will plough revenues into market structure research to benefit its users.

At this year’s TradeTech conference, a panel will be held on whether the Mifid II limits on trading and wavers are a help or hindrance to drive market liquidity.

The ‘all star panel’ takes place on day two of the conference at 11.20am, following refreshments in the exhibition hall.

Panelists include Union Investment’s Christoph Hock, the Financial Conduct Authority’s (FCA) Tom Springbett, and Morgan Stanley’s Rupert Fennelly and others.

The topics set to be discussed include the impact of dark pool caps, activities of HTFs and conflict of interest with brokers.

Whomever wins the war of words, the traditional model of dark trading is going to change out of all recognition.