End of a dark era

MiFID unwittingly created the broker crossing network (BCN), the growing popularity of which has fuelled an intense debate on equity market transparency. Will the MiFID review draw a veil over BCNs, as MEPs want, or just subject them to greater scrutiny?

What exactly is a broker crossing network (BCN) and how does it differ from other types of execution platforms? 

In some ways, the BCN is just the automation of an order matching service that brokers have always offered to clients. From another perspective, it is the unintended by-product of MiFID.

Regulators thought the three venue categories enshrined by the directive (regulated markets, multilateral trading facilities (MTFs) and systematic internalisers) combined with strict waivers that permitted certain venues to forego pre-trade quoting obligations, offered ample room for new and innovative execution platforms.

MTFs and exchanges launched dark books, including NYSE Euronext-owned SmartPool and BATS Chi-X Europe’s Chi-Delta, currently the largest non-displayed MTF in Europe.

But brokers went down a different path, deciding instead to create their own type of OTC venue. This gave the sell-side more control over entry criteria and matching rules, and imposed looser transparency obligations.

Is it dark trading regulators and politicians don’t like – or unregulated markets? 

They’re not especially keen on either. The ability for dark MTFs to avoid pre-trade transparency suggests a grudging acceptance that institutional investors need a means of executing in large size without risking market impact. Dark BCNs attract further suspicion, partly because brokers set their own rules but also because they are not subject to the same reporting requirements as other venues, thereby hampering market transparency.

Do BCNs account for enough trading volume to be a serious threat to price formation? 

Perhaps not, but the figures are far from insignificant. According to Thomson Reuters, BCNs traded €30.62 billion in March, compared to €30.46 billion for dark MTFs. Combined, the two types of non-displayed platform traded 7.24% of overall European equity trading.

The European Commission’s solution to the growth of unregulated dark volumes was to bring BCNs into the fold, making them a sub-set a new category, the organised trading facility (OTF), as part of its MiFID II proposals.

This approach would formally recognise BCNs and enable brokers to keep discretionary matching capabilities. But the OTF proposal prohibited their operators from including proprietary flow and imposed tougher pre- and post-trade transparency requirements.

Brokers were beginning to warm to the idea of OTFs, but in its amendments to MiFID II unveiled at the end of February, the European Parliament signaled its intention to scrap the OTF for equities, essentially forcing BCNs to turn into systematic internalisers or MTFs.

What kind of loss would this be to institutional investors? 

Go to any trading conference or talk to any head of desk and you are likely to get the same answer: “We want choice.”

To meet their best execution obligations, buy-side firms say they need the broadest range of execution channels possible. Buy-side traders have also repeatedly said that the discretion BCNs offer is crucial as they can rest orders in these venues safe in the knowledge that their broker is actively policing how executions take place.

But we’re still at a relatively early stage. The European Parliament will meet at the end of this month to discuss its MiFID II amendments, and the Council of the European Union is yet to have its say.

MEPs want as much order flow as possible to flow through regulated venues, preferably lit exchanges. But they do not appreciate the added cost of transparency that would ultimately be borne by the buy-side.

As one broker recently noted, “The ultimate impact may be the pursuit of transparency at the cost of choice, although it is not even clear that the objective of transparency will be met.”

Click here to vote in this month’s poll on theTRADEnews.com looking at the impact of a BCN ban on the buy-side.