Forced out of the shadows

The days of broker crossing networks could be numbered, with MiFID II sure to impose restrictions on how they operate. But such limitations could have a major impact on the buy-side's execution performance.

What do broker crossing networks (BCNs) give the buy-side that they can’t get from other liquidity sources?

From the buy-side’s perspective, the benefit of the BCN largely relates to the safety and quality of liquidity they offer.

With BCNs not being an official classification of trading venue under MiFID, brokers took the opportunity to exercise more flexibility in constructing their internal crossing venues compared to other types of dark pool. This includes determining the types of participants that are granted access, looser pre- and post-trade reporting obligations and more discretion on how orders are matched.

Comparatively, dark pools that are recognised under MiFID – largely consisting of those operated by MTFs and exchanges – must adhere to principles of open access and strict criteria on how orders are matched.

For the buy-side, the degree of control a broker has over its BCN means, in most cases, it forms part of an overall execution service.

A broker that is able to rest a portion of a client’s order in a BCN can typically deliver implicit cost savings through closer management of market impact (and cut its own costs by avoiding exchange fees).

Let’s also not forget that the dark pool was initially conceived as an off-exchange crossing network to help the buy-side manage market impact when trading large chunks of stock. This perception of the dark has been slowly eroded, with anecdotal evidence suggesting that high-frequency trading is becoming more prevalent in dark MTFs, although there are options – like buy-side focused Liquidnet – that aim to preclude this kind of flow.

The outcome is that dark pools are no longer considered as ‘safe’ as originally intended and trade sizes in them have gradually slid to levels typically associated with displayed exchanges.

Brokers are already addressing this perception that dark is dangerous. BCNs like Credit Suisse’s Crossfinder, which uses proprietary methodology to rank participants based on their trading behaviour, allow the buy-side to know exactly who they are trading against prior to execution and are more conducive to larger trade sizes.

What is the likely outcome for the buy-side if the BCN is no longer an execution option?

It’s hard to tell exactly how the buy-side’s behaviour might change and a lot has to do with where final regulatory proposals end up.

There are a number of possibilities though.

If, as MEPs crave, OTC equity trading is forced to go through systematic internalisers (SIs), off-exchange trading is sure to decline. SIs are at best ill-defined, and under current MiFID II proposals, will not be able to match two client orders. Crossing against house flow in an SI may not be as appealing.

Another prospect is that the reduction of order sizes that has occurred since MiFID could accelerate.

Forcing buy-side traders to execute on lit venues could mean orders need to be split up into even smaller chunks to avoid market impact, adding further costs and complexities to buy-side traders that want trade in blocks.

Further dark MTF innovation may also offer some help. In the last few weeks, Chi-X Europe founder Tony Mackay, CA Cheuvreux, Quote MTF and Societe Generale have announced new venues that aim to offer users a more controlled means of execution.

Surely there is some middle ground?

The closest thing we had to a workable solution that almost appeased both sides was the organised trading facility (OTF), introduced by the European Commission in its MiFID II draft last October.

Under the proposal, OTFs can discriminate on access, only match client orders and would have similar pre-trade transparency requirements as MTFs. On the face of it, this sounds like a pretty fair compromise and brokers were beginning to accept to the new category.

However, MEPs are trying their best to scotch the Commission’s plan by claiming the use of the BCN for equities would only create more fragmentation and leave room for further loopholes.

But an agreement on the final MiFID II text is still at least a year away, with the Council of the European Union yet to give its view.

There are plenty of twists and turns left in this saga, but right now a solution that restricts execution choice in a way that would have a material impact on the buy-side’s fund performance is where things are headed.

Click here to vote in this month's poll on