Dark pools warn of unintended consequences to waiver changes

European Council proposals to limit the use of reference price waivers in MiFID II could limit choice and lower investor returns, according to dark pool operators.

European Council proposals to limit the use of reference price waivers in MiFID II could limit choice and lower investor returns, according to dark pool operators.

Last week, a Council discussion paper called for use of reference price waivers, which enable a significant amount of dark trading on multilateral trading facilities (MTFs) and dark order books at regulated exchanges, to be limited to trades where price improvement has been achieved by matching at the mid-point, a measure supported by the European Parliament.

The original MiFID set out numerous price transparency waivers, which could be used if trades met certain conditions and enabled market participants to make information about their order public until a trade had completed. As well as the reference price waiver, there are also large-in-scale waivers for block trades, negotiated transaction waiver that are used in Broker internal pools, and order management waivers that enable large orders to be split without being made transparent.

The Council also continued to push proposals for a cap on total dark trading volumes in individual stocks to no more than 4% on a given venue and 8% overall.

However, Richard Semark, CEO of UBS MTF, which is one of the largest dark MTFs in Europe and makes use of reference price waivers, is concerned that the moves will unfairly limit choice for market participants.

“There are benefits to trading in the dark at the same price as you would in the lit market as you might want to keep market impact to a minimum. Focusing on the mid-point would restrict the choices available to institutional investors,” he said.

Semark also questioned regulators’ focus on dark pools as being obstacles to price formation.

“Regulators seem to believe that price formation can only happen in the lit market, but both MTFs and broker crossing networks (BCNs) print immediately and the post-trade is just as important as the pre-trade. Market participants also weight a number of other factors such as historic price and volume that also contribute to price formation.”

Despite Semark’s reservations on the move to limit the use of waivers to the midpoint, the move has seen fairly broad support.

Support for mid-point

Among the supporters is Liquidnet Europe’s Head of International Corporate Strategy, Per Lovén, who said that while restricting the use of waivers would see a fall in the amount of dark trading it would not curb the benefits that dark trading offers.

“The market has seen some growth in dark trading taking place at bid or offer and in small size. This to some extent goes against the reason for dark pools existing in the first place. Dark pools were created to offer price improvement and/or minimising market impact. The model of requiring price improvement has been adopted most recently in Australia and this has been positive for both the lit book, block and mid-point trading,” he explained. Liquidnet uses both the reference price waiver and large-in-scale waiver as part of its dark trading platform.

The large-in-scale waiver, which enables market participants to avoid pre-trade transparency rules provided they trade a sufficiently large block, is expected to continue in MiFID II without being restricted to mid-point transactions.

The change in reference price waivers could also see alterations in trading strategy by some market participants and would not necessarily push more trades onto the lit market.

“You may see changes in the behaviour of market participants, who might opt to use the large-in-scale waiver to do block trades instead of trading in the lit market. It’s wrong to assume that constraining dark trading will mean all that volume moves towards the lit market,” explained Semark.

Arbitrary cap

Lovén said he remains concerned that European regulators are continuing to pursue a cap on dark trading and believes it will ultimately lead to lower returns for end-investors.

“The amount of trading that takes place in the dark should be dependent on the value it provides to end-investors and the overall market, not some arbitrary volume cap,” he said.

Sources close to Brussels say a further announcement on the trialogue’s progress – the process where the European Commission, Council of Europe and European Parliament will agree the final text of MiFID II and the European market infrastructure regulation – is due on Friday with the Commission expected to lay out its latest stance on dark pools.

Recent research by Tabb Group put European dark trading volume at 11% of the market total in 2013 so far when trades from BCNs are included, significantly higher than the proposed 8% cap.