Brussel’s changes to MiFID II as part of its Capital Markets Union (CMU) review in November reaffirmed Europe’s stance on dark trading. Since the implementation of MiFID II in 2018, the continent has made it clear that it intends to hold transparency above all else in a bid to foster protection for retail investors in the capital markets, a crusade that would have included the UK, had it not been for Brexit.
However, following the UK’s departure from the European Union, the two parties have had opposing priorities. While the EU has been focused on continuing to curb the growing amount of volumes taking place off-book, the UK has been intent on reinventing itself to make it a more attractive place to do business following the loss of almost all its EU share trading business back to the continent.
“The balkanisation of liquidity story is definitely playing out now. I think that some of the market practitioners were hoping – naively or otherwise – that there wouldn’t be so much divergence so quickly, but I think now that ship has sailed and we’re definitely seeing that happen,” said James Baugh, head of European market structure at Cowen. “It’s [Europe’s MiFID II changes] all part of that narrative to try to curtail the amount of business transacted on MTF darks, as well as, continuing to apply pressure on systematic internalisers to try and push more of that business to lit.”
The key objective of MiFID II was to move volumes back onto lit markets, introducing things like the double volume caps (DVCs) for dark trading to do so. However, much of this liquidity has since resurfaced on alternative trading mechanisms with limited pre-trade transparency, including systematic internalisers (SIs) and frequent batch auctions (FBAs) which Europe has now set its sights on with its latest tweaks to the rulebook alongside additional limits to dark trading.
“Most of us predicted divergence between the UK and EU 27. MiFID II is all about getting liquidity back into the lit transparent environment. Whereas, on the UK side because of Brexit we’re seeing a different political move, which is how do we liberate the UK in such a way to attract business to it? That’s a very different problem to solve,” said Alasdair Haynes, chief executive officer of Aquis Exchange.
Successful lobbying from incumbent regulated markets has meant Europe has continued to favour transparent lit markets in its regulatory updates and if the UK’s stance diverges from this too dramatically in the coming months, then market participants could be left with a fragmented liquidity landscape and subsequent increased cost of trading to navigate.
“These proposals have the potential to alter how people think about executing their order flow in the UK and Europe. I think most market participants would agree that there’s a case to be made for more simplicity in market regulations and I think divergence doesn’t help that aspiration,” said Ed Wicks, head of trading at Legal & General Investment Management.
Into the light
Among the changes implemented by the European Commission is the replacement of double volume caps (DVCs) with a single volume cap (SVC) of 7% across Europe in a bid to further reduce the amount of dark trading on the continent. This system replaced an 8% cap on participants and 4% cap on venues, which most agree was overly complex.
More specifically, the recent changes made by Brussels seem to be intent on driving small trade volumes back onto lit markets and are focused predominantly on anything below Large in Scale (LiS). According to data by Liquidnet’s Liquidity Landscape, the implementation of MiFID II at the beginning of 2018 saw the proportion of the dark market traded above LiS in Europe, the Middle East and Africa (EMEA) double from 20% to 40%. Regulators in Europe are now looking to make that percentage higher still.
Among its methods for doing so is the prohibition of alternative trading venues (MTFs) from using the reference price waiver to execute small trades in Europe, due to a new minimum threshold of two times standard market size. The changes are not the worst-case scenario for MTFs and dark trading in Europe, with many speculating that regulators intended to remove LiS thresholds for dark trading altogether. Whether this is something that is reconsidered later down the line will have to be seen.
“Studies show that there is quite a lot of volume below that threshold that does currently occur on SIs and dark venues. If the proposals were to go forward in their current form, some of that flow could be encouraged onto lit markets. Large orders, they [Europe] can clearly see a rationale for dark trading,” adds Wicks.
Regulators are seemingly aware that historically when they have squeezed dark trading, alternative venues such as systematic internalisers (SIs) and frequent batch auctions (FBAs) have seen an increase in volumes and it is these quasi-dark corners of the market that they are subsequently shining a light into, both through their recent update to MiFID II and their potential future regulatory updates that could follow the RTS 1 and 2 consultations.
“Europe is trying to carry on that transparency process in more areas where they didn’t go as far as they needed to,” said Gareth Exton, head of execution and quantitative services for EMEA at Liquidnet. “It’s now these other things that have come up because of MiFID II, which is the FBAs and the SIs, which they now want to have a have a go at. It’s trying to now shine a bit more of a light onto what’s happening pre-trade.”
Systematic internaliser volumes have on occasion been inflated in Europe by regulators. In June 2021, ESMA published a set of data claiming that on-venue equities trading was in steady decline with SIs labelled one of the main culprits. The report followed data in November 2019, that had found that the Goldman Sachs SI had dominated European equity trading that year, however, this conclusion was later deemed to have been generated with an incorrect data set. The number was inflated by clearing trades, due to the size of the investment bank’s prime brokerage business. The regulator was consequently called out by various industry associations, including Oxera and AFME, for its inaccurate perception of the marketplace. According to Liquidnet, systematic internalisers in the third quarter of this year made up 13% of the overall trading volume in Europe.
In its recent changes to MiFID II, several changes were recommended by the Commission to curb SIs, including upping the minimum quote size to two times standard market size (SMS) and limiting their ability to match at mid-point to when they are trading above twice the standard market size, but below the LiS threshold, while complying with the tick size as well as above LIS. It should be noted, the two times SMS is just a quote size and SIs can trade below that. Regulators have also suggested prohibiting payment for order flow for SIs, instead requiring them to earn retail flow by publishing competitive pre-trade quotes in another move to force smaller trades back into the regulated markets. The Street is mixed in its approach to the changes to the SI regime, with many buy-side firms seeing the benefit of liquidity provided by the mechanisms, particularly when it comes to small orders.
“If you think about in order that you may be trading on a scheduled basis over a period of time, you’re naturally going to have that parent order broken into smaller chunks and for some of those you would still want to benefit from some of the features that potentially SI liquidity can give you,” adds Wicks.
Proposed changes to FBA pre-trade transparency as part of the RTS 1 and 2 consultations – the results of which are still being deliberated – are even less welcome than the changes to SIs. The mechanisms were first introduced into the market as a method for participants to skirt the DVCs originally implemented as part of MiFID II in 2018. If a stock was capped, it could be traded in the lit market with a reference price. They rely on limited transparency pre-trade to function properly due to the inherent speed bumps within them.
RTS 1 and 2 have set out proposals to make these auctions more transparent. However, many have argued that the level suggested by European authorities could expose them to information leakage, which could ultimately leave participants subject to arbitrage strategies in the continuous trading market. ESMA has set out two potential new definitions for FBA transparency, with its preferred option allowing for the publication of individual orders prior to a match being identified. This is contentious as orders published in auctions must sit and wait for the auction to uncross for 100 milliseconds while the continuous trading market could act upon them.
“FBAs – which share the same pre-trade transparency model and price-forming algorithms of Closing Auctions – create a level playing field and deliver huge benefits to institutional investors ill-equipped to execute in low-latency environments. It is abundantly clear that ESMA’s proposals to introduce additional pre-trade transparency will in fact entirely destroy the usefulness to investors of EU-based FBAs,” says Nick Dutton, chief regulatory officer at Cboe Europe. “Given that the current transparency regime for these venues had already been reviewed by ESMA and deemed appropriate, we hope ESMA will conclude that its more recent suggestions should not be taken forward. Decisions to restrict venue choice within the EU, to the detriment of investors, should only be taken on evidence of a clear conflict between serving investors’ needs and maintaining efficient price formation, and we strongly believe no such evidence exists.”
A liberal UK
With regards to market transparency and dark trading, the UK has taken a contradictory stance to Europe following the end of the Brexit transition period at the end of 2020, largely to foster new interest in its markets. On the 4 January 2021, as the markets opened following the 31 December deadline, north of 95% of European share trading volumes had migrated to the EU from the UK, totalling around
¤6 billion of daily trading volume. Following this loss, it was rightly predicted that the UK would try to lure some of these volumes back to its shores by liberalising areas where the EU is becoming more stringent.
The UK is yet to make any concrete changes to its regulatory framework, however, in its Wholesale Markets Review (WMR) HM Treasury has put out feelers to the industry asking for suggestions on current market structure, with dark trading being one topic at the forefront of discussion. “It feels to me that the European perspective is seemingly more prescriptive in how they think about dark trading whereas the UK seems to be slightly more market led,” says Wicks.
Across the various areas in which the EU appears to be clamping down, the UK has taken a relaxed and liberalised approach, for example, scrapping DVCs all together. In the WMR it cites the US market as an example that has no such cap and yet whose dark trading volumes have plateaued at 10%. Elsewhere, it is proposing to make no changes to the current periodic auction regime and has also proposed to allow SIs to execute client orders at the mid-point within the best bid and offer for trades below LiS, provided the executed price is within the SIs’ quoted prices and the execution is in a size no larger than that which is quoted. Under the WMR’s proposals, reference price systems will also be able to match orders at the mid-point within the current bid and offer of any UK or non-UK trading venue that offers the best bid or offer.
Be careful what you wish for
While the UK may begin to attract more business by liberalising, some have warned that regulators in the UK must be careful what they wish for. These individuals argue that if too much trading takes place in the dark, it could lead to a degradation of the reference price in the lit market, which in turn could damage midpoint trading and prevent end investors from achieving best execution. Data by big xyt found that market share on price referencing as opposed to price forming mechanisms in the UK, including dark venues, FBAs and SIs, has grown from 12% in the first quarter of 2018 to 21% in the fourth quarter of this year. This number can only be expected to rise if regulatory changes make the UK a more attractive place for volumes driven out of the EU.
“If the UK liberalises so much that price discovery becomes meaningless and we end up in a marketplace that looks more like the foreign exchange market rather than the equity market,” says Haynes, “It could be creating a problem that shifts more business back to Europe. So, this is going to be incredibly interesting to watch for the next year as errors could be made on both sides with pretty dramatic outcomes for the industry as a whole.”
The UK’s WMR – citing an FCA paper from 2017 – states that a damaging level of dark trading could range from about 11%–17% and therefore the text of the proposals maintains that the level of dark trading in the UK will continue to be monitored and reserves the right for UK authorities to retain the ultimate sanction to limit dark trading should it become unmanageable. “They will retain that handbrake, if you like, so I think there is an acknowledgement that there may be a threshold that if crossed becomes harmful to price formation or to effective market operation,” adds Wicks.
The number of capped out stocks in the EU has remained consistently low, so many argue that this level of dark trading is difficult to reach with or without a cap. The EU also set out plans to implement a single consolidated tape for each asset class in its MiFID II amendments also going some way to alleviating concerns about an inaccurate reference price caused by too much dark trading.
These diverging approaches to different market mechanisms and venues on either side of the channel following Brexit means in the not too distant future market participants could be forced to navigate a fragmented liquidity landscape, which in turn will bring several other hurdles to overcome, including increased costs of trading and a less inclusive trading environment.
While dark trading, systematic internaliser, and FBA volumes in Europe have not increased astronomically, they have grown. From the first quarter of 2018, addressable market share excluding prints above LiS and outside of market hours across these three areas in German blue chip stocks grew from 8% to 15% in the fourth quarter of this year, according to data published by big xyt.
If the UK makes itself the more attractive place for these volumes to trade then a portion of them could be forced out of the EU and back onto UK venues, much to the dismay of the pan-European trading venues who set up European branches in a bid to accommodate the shift of EU share trading post-Brexit. Said venues with dark books would be the short-term winners, however, ultimately fragmentation will lead to higher costs for everyone. Worse still this liquidity could be pushed out into third countries meaning it’s a lose-lose for both the UK and Europe.
“I never believed that business could ever come back to the United Kingdom, but this is an extraordinary football match because in some ways it looks like the European Union could also be making a spectacular own goal of themselves if they are too stringent against the liberalised market,” says Haynes. “What happens is some of the liquidity is shipped back to London and a large liquidity pool is divided and everybody loses, everybody’s a loser there because spreads will widen and markets become less liquid. It is better to have 100% of a particular market in a single place because that is where you get most liquidity.”
What’s more, with EU investors limited to where they can trade by the share trading obligation (STO) – also scrapped by the UK – diverged and fragmented markets also have the potential to exclude a large portion of these investors from certain pools of liquidity. Around 80% of institutional order flow in Europe is international, meaning they’re not bound by Europe’s STO and could take the party elsewhere.
“Suddenly you may have an EU asset manager unable to access the liquidity that’s taking place on EU venues between other global asset managers and it all starts to get very tricky,” adds Exton. “Then you get the potential of Europe reacting to that and the creation of ‘fortress Europe’.”
Increased trading costs
A fragmented liquidity landscape presents several issues around the cost of trading, forcing participants and venues to set up dual operations, all of which are additive costs that eventually trickle down into the market. Code bases for algorithms become more complicated and complexity is added to offering different services for different securities in different jurisdictions.
“When you think about trading larger size block business clearly the reason why the market has alternatives is to facilitate that type of workflow so as not to negatively impact the underlying price of a given stock,” says Baugh. “It could become more expensive to trade in Europe because the implicit costs of trading go up on the basis that there are less choices available, particularly to institutional investors. Too much fragmentation will also certainly lead to an increase in direct costs from stitching these different liquidity pools back together, but also just in terms of the implicit costs of trading for the end investor themselves.”
With the re-introduction of certain EU securities expected to follow regulatory divergence, the cost of trading in London is also expected to go up. According to statistics from Cowen, for the first six months following the re-introduction of Swiss securities into London in February, the implicit cost of trading rose by around half a basis point, and this number was increased further for smaller trades. “One might say this is the cost of competition – facilitating certain time sensitive arbitrage strategies, which tend to trade in smaller sizes – a pattern we’ve seen in other competing markets,” Baugh adds.
As it stands the ball is now in the UK’s court. With the results of its Wholesale Markets Review due to come into play early next year it must decide how extensive its liberalisation will be following the recent MiFID II changes proposed by Europe. If too liberal, it could spark a shift in liquidity that fragments the markets once again, just a year after the dust has settled post-Brexit. Regulators on either side of the channel are pulling in opposing directions and this brings with it the likelihood that participants in the not too distant future will be executing in a divergent and fragmented world. Hold on to your hats.
“You’ve now got two almost diametrically opposed views of liberalisation on one side of the channel and trying to create a more effective price discovery mechanism on the other. The irony of it is that we probably should aim for something in between, but because of the various politics that’s going on we’re seeing this massive divergence taking place,” concludes Haynes.
“Unfortunately, the structure of the market is such that there is no such thing as a lit market that is perfect today and as a result we brought in dark trading to find other mechanisms to be able to allow people to trade in size without moving price. You need to change the lit books to make them more effective, make them more liquid and get more people to trade in the lit environment so that you get the right prices.”