The Federation of European Securities Exchanges (FESE) has said it would support restricting European non-displayed trading venues to executing large sized orders, going a step further than CESR, the pan-European securities regulator, which yesterday proposed a minimum order size for dark pools that use MiFID’s reference price waiver.
On 14 April, the Committee of European Securities Regulators (CESR), the body responsible for supervisory convergence across Europe’s securities markets, released a consultation paper on reforming MiFID that outlined a range of potential changes for the regulation of dark pools, which also includes a redefinition of the large-in-scale thresholds to take account of dwindling average order sizes. The consultation paper – one of three issued simultaneously by CESR – will feed into the European Commission’s review of the directive scheduled for later in the year.
Dark pools have existed informally for some time but usage has increased in recent years, in part due to traders’ desire to limit market impact for large orders. MiFID introduced a series of waivers that would allow dark pools to avoid the directive’s rules of the publication of pre-trade quotes. According to FESE, which represents the interests of 42 stock exchanges across Europe, dark pools should only be used for trading large orders that are unsuitable for lit trading venues. However, many non-displayed multilateral trading facilities (MTFs), such as BATS Europe’s dark pool and Chi-X Europe’s Chi-Delta, as well as broker internal crossing engines also allow smaller orders to be traded in them.
“From a price formation perspective, the concept of dark pools should only be applied for large orders, both for broker-dealer dark pools and non-displayed MTFs,” Burçak Inel, deputy secretary general, FESE, told theTRADEnews.com. “The concept of executing smaller orders without pre-trade transparency is out of line with the spirit of MiFID.”
Under MiFID, trading venues can remain dark if: an order is large-in-scale, i.e. above a certain proportion of the average daily turnover or market capitalisation of that stock, as defined by CESR; quotes for non-displayed orders are pegged to a reliable reference market; or trades are negotiated privately between two counterparties. FESE contends that all waivers – not just the large-in-scale waiver – should be subject to size limits, although it has not specified what these limits should be.
In its consultation paper, CESR also recognised worries from the industry on the trading of small orders in the dark. “Some concerns have been raised that reference price systems are being used to execute small orders and it has been suggested that this is inconsistent with the general intention of the waivers to provide protection against market impact,” read the paper.
But dark pool operators and brokers have argued that FESE’s suggestion would restrict competition and limit innovation.
“If all dark pools were subject to size restrictions, you would effectively be imposing a concentration rule by stealth,” said Chris Marsh, head of trading and product development, Advanced Execution Services, Credit Suisse, which operates the Crossfinder dark pool, registered under MiFID as a systematic internaliser (SI). “If you force concentration in size, you will not be able to use technology to split up orders and get the best volumes at the best prices in the most efficient manner.”
Furthermore, Denzil Jenkins, director of regulation at Chi-X Europe, contends that further restrictions on size for dark pools could push more equity trading away from public exchanges.
“Having diversity and a choice of where to trade orders is crucial, from block crossing to systems which allow smaller reference priced orders, especially in a constantly evolving automated trading environment,” said Jenkins. “A size limitation for publicly accessible dark books such as Chi Delta is also likely to be counter-productive and push orders off exchange to over-the-counter (OTC) channels, as investors would look for other ways to limit market impact.”
Buy-side firms agree that their trading would be forced elsewhere at potentially higher costs if dark pools had size limits.
“With a minimum size restriction, I would either be forced to trade in the lit markets or use OTC channels,” affirms Sören Steinert, head of trading at Frankfurt-based quantitative investment management firm Quoniam Asset Management, which trades around 35% of its orders in the dark. “In the worst case scenario, I may have to pay the whole spread using an aggressive algorithm, instead of matching at the mid-point in the dark, and pay higher market impact costs. In addition, some smaller buy-side firms that do not trade blocks of stocks would not be able to use dark pools at all.”
CESR’s consultation paper also included the findings of an investigation it conducted in Q4 2009 to determine the level of dark trading in Europe. CESR found that dark trading on MTFs and regulated exchanges accounted for 9.8% of total European equities trading in Q4 2009, up from 6.7% in Q1 2008. However, 4.1% of the 9.8% figure for Q4 2009 was executed by one jurisdiction using the large-in-scale waiver, and only 0.9% of the total was transacted by dark pools using the reference price waiver.
As such, Jenkins argues that further restrictions on dark trading in Europe are needless.
“The proportion of overall business transacted in dark systems is very small in Europe, and any further restrictions need to be considered in this context,” he said. “Furthermore, most dark pools using the reference price waiver, including Chi-Delta, have the capability for users to set their own size thresholds anyway, which raises more questions as to whether the FESE suggestion is necessary.”
FESE’s suggestion reflects long-standing tension between exchanges and brokers about the impact of dark trading on European equity markets.
Last year, FESE pushed for the reclassification of broker crossing networks that are not registered as MTFs or SIs, arguing that such systems perform the same functions as MTFs, but are not subject to the same standards of regulation in terms of fair and open access, surveillance and reporting obligations. Brokers counter that their crossing engines are already subject to strict regulations and are also driven by their best execution obligations to clients under MiFID.
Under MiFID, broker dark pools not registered as SIs or MTFs should be used for over-the-counter trades, which the directive defines as dealings above standard market size and performed outside the systems usually used by a firm for its SI business. These are subject to post-trade transparency only.
By comparison, SIs are described in MiFID as “an investment firm, which, on an organised, frequent and systematic basis, deals on its own account by executing client orders outside a regulated market or an MTF”. SIs are required to publish pre-trade quotes for orders in liquid shares below a standard market size.
The problems surrounding the classification of broker crossing engines were also identified in CESR’s consultation paper. For SIs, CESR proposed three changes including requirements for SIs to provide two-sided quotes, maintain a minimum quote size equivalent to 10% of the standard market size of any liquid share and to identify themselves in post-trade reports. At the moment, SIs only need to quote one-sided an in a size of one share, meaning very little information on the size of business available in SIs is available.
For brokers operating crossing engines registered as OTC venues, CESR has asked the market whether such venues should be reclassified as MTFs when they reach a certain market share threshold. CESR reported in its paper that 1.4% of total trading in Europe is conducted in broker crossing engines that are not registered as SIs or MTFs.