FCA study highlights dark trading cap problems

Dark trading negatively affects the market at 11% and 17% of market turnover, yet MiFID II’s proposed dark pool caps are set at 4% and 8%.

The UK’s financial watchdog has found dark trading begins to negatively affect market quality between 11% and 17% of market turnover, much higher than MiFID II’s proposed dark pool caps.

The study authored by the Financial Conduct Authority (FCA) looked at the 350 largest UK stocks traded across the four main trading venues in London.

It found ‘a non-linear relationship’ between the proxies of market quality and dark trading, meaning at higher levels dark trading could be more harmful to market quality.

“For our full sample of stocks, the impact of dark trading on market quality starts to turn sour anywhere between 11% and 17%, depending on the market quality proxy being examined,” the FCA said.

However, MiFID II’s dark pool restrictions introduce a double volume-cap, triggering bans on certain types of dark trading when a transaction accounts for 4% of the total activity on a single dark venue, or 8% of total trading market-wide.

Trades breaching the 4% venue-specific cap will be subject to a 6-month ban on the venue in question, while issues exceeding the 8% market-wide cap trigger a 6-month dark trading ban across Europe.

MiFID II’s dark trading rules have been widely debated among industry participants. Speaking at TradeTech earlier this year, the dark trading caps were described as detrimental to the market and ‘arbitrary’.

“Any regulation that limits buyers and sellers coming together at an agreed price is wrong for the market place. The volume caps are very arbitrary numbers,” said Ralston Roberts, co-head of electronic trading at Goldman Sachs in Europe.

The FCA’s study also found of the 350 stocks in the sample, just over 8% breach the 8% cap. However, other studies have suggested significantly more stocks could breach the cap. 

A report from Rosenblatt Securities published in June this year measured how the dark trading caps would affect trading in 757 stocks across 18 major European indexes, with data provided by Bats Europe.

It found just fewer than three-quarters of stocks would hit the 8% threshold, with UK and Irish stocks hit hardest.

Overall, 89% of stocks in the FTSE 100 and FTSE 250 will breach MiFID II’s dark trading market-wide cap come January 2018, according to the study.

The FCA concluded it is important that “policy makers take care not to eliminate the market quality benefits of dark trading by arbitrarily imposing uniform dark trading restrictions for all stock sizes”.