The European Parliament's Committee on Economic and Monetary Affairs (ECON) has adopted a report that recommends that all broker dark pools be reclassified as multilateral trading facilities (MTFs) or systematic internalisers (SIs), and that dark executions should be subject to size restrictions.
The report, called ”Regulation of trading in financial instruments: dark pools etc’, drafted by Kay Swinburne, MEP for the Welsh Conservative Party and the paper’s rapporteur, was voted through on 9 November by the ECON and establishes the position of the European Parliament for the key issues that are likely to be part of the MiFID review. The results of the vote were 43 for and two against the revised version of the report.
The paper places a large focus on improving price formation in displayed markets and ensuring a level playing field between different types of trading venues.
“Buy-side firms indicated that they felt some market participants were disenfranchising them, which has led to a deliberate movement of orders to broker dark pools,” Swinburne told theTRADEnews.com. “The collective view of the European Parliament is to encourage the movement of dark trading back into the regulated lit space, so it contributes to price formation. But we agree that more work needs to be done to determine why more trading is taking place in the dark.”
The report's findings build on the technical advice issued earlier this year by the Committee of European Securities Regulators (CESR), which holds responsibility for coordinating securities regulation across Europe.
CESR's technical advice is a pre-cursor to the MiFID review. The European Commission is set to start its own MiFID consultation at the end of this month, with a formal report detailing revisions to MiFID expected in April 2011.
Swinburne's report is an ”own initiative paper' designed to act as further informal guidance to the European Commission before it proposes its own amendments to MiFID early next year.
“Much like CESR's consultation papers released in recent months, the Swinburne report will be one of the components that informs the final shape of the second version of MiFID,” said Anthony Kirby, director, regulatory and risk management at Ernst and Young. “You are likely to see different groups – the European Commission, lobbying agencies, financial ministers in the European Council and the European Parliament – all bring different issues to bear around MiFID before a revised version of the legislation is tabled.”
The original paper published by Swinburne in July had a focus on dark trading, broker crossing systems, pre- and post-trade transparency and high-frequency trading. It proposed improving the definition of a systematic internaliser in order to increase its use as a subset of OTC trading and a new framework for broker crossing networks, including an investigation into CESR's proposal to convert them into MTFs should they reach a certain level of market share. It also called for alterations to the waivers used to exempt trading venues from publishing pre-trade quotes, such as a reduction to the large-in-scale waiver, and the imposition of a minimum size threshold for dark pools that use the reference price waiver.
But after its initial publication, MEPs from other European political groups put forward amendments that were voted on and approved on 9 November, including concerns over the proportion of trading conducted over-the-counter – which was deemed too large, with half of transactions below standard market size – and an ”in-depth investigation' into the business models of broker dark pools to determine whether they should be classified as SIs or MTFs, rather than falling into their own separate category. In addition, the paper urged the EC to look at the possibility of imposing a size threshold for all dark executions to encourage greater use of displayed trading venues.
“Forty per cent of trading volume is still carried out OTC [and] market participants should be encouraged to transact more on organised trading venues,” read the paper. “The absence of sufficient regulation for OTC transactions, including broker crossing networks, provides a competitive advantage to the OTC space and encourages an increase in trading in the dark, undermining market transparency.”
These issues could be a blow for brokers, which may face increased pressure on the business they execute in their internal dark pools. Although some brokers argue that their business is unsuitable for the SI or MTF category, they have faced staunch opposition from the likes of trade body the Federation of European Securities Exchanges, which argues that BCNs perform the same function as regulated markets and should be governed as such.
If suggestions to impose a minimum threshold for all dark transactions are upheld it could also significantly change the order flow found in dark MTFs, such as Chi-X Europe's Chi-Delta, BATS Dark and Turquoise's mid-point dark book, which see relatively small trade sizes that are similar to those of lit markets.
“Most market participants agree that trading on non-displayed venues in Europe makes up less than 3% of the total. In the US, this figure is much higher than in Europe at around 12% and yet there is no quantitative evidence to suggest that there is any negative impact on price discovery in the US,” said Bradley Duke, managing director at broker Knight Capital. “If anything their markets are more efficient with tighter spreads – all this without any mandated size thresholds on non-displayed orders.”
The approved version of the report also calls for an investigation into the risks associated with high-frequency trading strategies following the ”flash crash'' in the US on 6 May and for further examination of the costs and benefits associated with algorithmic trading. It also supports the unbundling of trade and quote data from reporting venues – something exchanges have already committed to deliver by the end of 2010 – and the introduction of Approved Publication Arrangements, vehicles that would be responsible for ensuring the quality of post-trade data to enable easier consolidation.
“This report should be applauded for tackling some of the most controversial issues,” added Kirby, “but there are still some fundamental issues – such as a universal clock across Europe for applying circuit breakers that need to be addressed. There should also be legal definitions around the definition of an order, indication and execution so that debates around issues like high-frequency trading can be studied more effectively,”
Following its adoption by ECON, the paper will now be presented to the rest of European Parliament for full adoption.
After the EC's formal proposal to amend MiFID has been published next April, it must be examined and amended by both the European Parliament and the European Council. Following the revisions, both versions will be reconciled and then adopted into law.
“We consider the report to be a marker in the ground for the European Commission for their consultation,” said Swinburne. “We feel we have raised investor awareness of the MiFID review ahead of the formal legislative process.