MiFID II “will force trades back onto lit market”

Industry told that MiFID II's dark pool caps will inevitably force flow back onto lit markets, where it risks being gamed by other market participants.

Restrictions under the Markets in Financial Instruments Directive II (MiFID II) around the amount of trading activity that can occur in dark pools will force institutional investors to trade in lit markets where their intentions could be spotted or gamed, it has been warned.

MiFID II, which is due to be implemented on January 3, 2017, will impose thresholds on individual stocks that can be traded at any given dark pool at 4%, and across dark pools at 8%. Dark pools help provide liquidity in capital markets by posting trades publicly once transactions are completed allowing institutional investors to trade without adversely moving the market.

 “The new regime is trying to limit activity for smaller orders to trade in the dark, by imposing 4% and 8% volume caps for any dark pool trade that uses the reference price waiver. By doing so, market participants will lose the ability for price improvement on smaller orders, as most dark pool trades are based on a mid-point match. When this facility is removed, then investors have to pay the spread and lose spread capture – which ultimately affects execution quality,” said Michael Horan, head of trading services at BNY Mellon Pershing.

The shift to lit exchanges could restrict liquidity and hurt institutional investors. “The shift from dark exchanges may restrict liquidity by forcing block trades into full view of the wider market. Investors who may have previously driven large volumes through dark pools may be discouraged from trading for fear their moves will be identified by the likes of high frequency traders acting upon their intentions and causing the market to move against them. It may be harder for dark pools to provide ready sources of liquidity to unwind or add large positions as a result,” said Horan.

Firms have been preparing for the changes MiFID II will bring. The London Stock Exchange (LSE), introduced enhancements in October 2015 to its hidden Mid-Price Pegged Order functionality, designed to facilitate large-in-scale dark trading directly on the SETS order book. The enhancements allow market participants to enter an order above the Large-in-Scale threshold specified by the European Securities and Markets Authority (ESMA) at the mid-point without displaying either price or volume to other participants.

Concerns have been mounting about dark pools, particularly about their lack of transparency and fears that they are being gamed by high-frequency traders (HFTs). “The majority of dark pools do not endorse or support nefarious activity. With the wealth of transaction cost analysis tools at our disposal, it is becoming easier to identify if client orders have been adversely selected in a dark pool. We monitor these on a daily basis and trust the vast majority of fills we get from dark pool trading,” said Horan.