Moving towards the light

Have trading volumes moved onto lit venues following MiFID II’s restrictions on dark trading and the rise of systematic internalisers? Hayley McDowell examines.

One of the fundamental objectives of MiFID II is to increase transparency and move trading activity onto lit venues, but weeks into the regime record block trading and periodic auction volumes have dominated regulatory headlines. Large-in-scale (LIS) venues were widely tipped to be beneficiaries of new requirements which saw the closure of broker crossing networks (BCNs) and the rise of systematic internalisers (SIs).

In the previous edition of The TRADE magazine, published just weeks before MiFID II came into effect on 3 January, industry participants and experts dissected the block trading landscape and made predictions on the migration of order flow from BCNs. One trend became clear – periodic auctions, LIS venues and finally SIs were the venues to bet on in a post-MiFID II world, not necessarily on-exchange or lit venues.

In a Liquidnet member presentation in February the firm said that, at a high level at least, there hasn’t been a significant difference in dark and lit activity, and lit volumes experienced no major change since 3 January. Instead, Liquidnet saw that periodic auction volumes had exploded, LIS activity had continued to increase and SIs even snuck in to steal a slice of the pie.

Less than two weeks after MiFID II finally came into force, Neil Bond, head of trading at Ardevora, offered The TRADE his insight as to where activity had migrated in those early days of the new regime. “Following the closure of BCNs, it seems periodic auctions have absorbed the majority of buy-side to buy-side crossing that was initially going through those venues,” he said.

Bond’s observation is clearly validated by a surge in volumes across various periodic auction venues during MiFID II’s infancy. The Cboe Periodic Auctions book, for example, saw a record month of trading volume totalling more than €6.5 billion during January, and average daily notional value (ADNV) traded reached €296 million, a massive 885.3% increase compared to the fourth quarter in 2017.

Dark delay and data difficulties

Periodic auctions are widely expected to sweep up even more order flow following the introduction of the double volumes caps (DVCs) for dark pools, which were delayed just one week into the MiFID II regime until 12 March by the EU markets watchdog. The European Securities and Markets Authority (ESMA) said in a statement released on 9 January that the data received from trading venues since MiFID II went live six days prior was insufficient and did not allow for a ‘meaningful’ and ‘comprehensive’ calculation of the planned DVCs.

“The ban on BCNs has helped to boost periodic auction volumes,” says Anish Puaar, market structure analyst for Europe at Rosenblatt Securities. “Most periodic auctions offer broker priority which gives brokers a low-cost, transparent way of matching client orders that used to reside in BCNs.”

Even this early into the new regulatory regime it has become clear that data and reporting are significant issues to address. Confusion around SI reporting requirements has skewed the data, and a large proportion of transactions that were previously reported as over-the-counter (OTC) are now being reported as SI activity. It’s the same story with periodic auctions: what percentage of transactions executed through auctions is price forming or pre-matched?

As it stands, the data is simply not granular enough and various different parties are coming up with their own estimates instead, making it near impossible to draw any firm or definitive conclusions from the available data sets.

Regulators including the UK’s Financial Conduct Authority (FCA) are supposedly keen to dive into the details of orders executed on auctions, prompting speculation that there could be tighter restrictions on how they operate in the future.

“With both SIs and periodic auctions, it is quite difficult to figure out what is addressable liquidity and what isn’t,” says Tim Cave, a European market structure analyst at TABB Group. “It’s really up to the industry to come together and standardise how transactions are reported, particularly through SIs, to provide a better understanding of where liquidity is residing. Overall, there hasn’t been a huge shift towards lit venues which was of course the intention of MiFID II, so regulators will be watching this closely.”

Ardervora’s Bond also raised doubts over the early buy-side adoption of SIs. “I believe SIs have absorbed the rest of that activity and internal SIs are probably trying to get as much as possible done,” he said. “While larger institutions test the waters with external SIs, I don’t think the buy side will fully embrace external SIs until they have solid data on performance on those venues. They are being used, but not widely across the buy side.”

Cave adds the DVCs will see buy-side firms taking a closer look at SIs and there should be more execution data ready for analysis. “SIs are a new way of trading for the buy side and, as with any new venue, they want to able to analyse execution quality before utilising them properly to ensure they are offering best execution,” he says.

Teething problems

Block trading and LIS venues have certainly thrived in the new, post-MiFID II world. Fidessa’s Top of the Blocks report reveals just how far block trading has come over the past year alone, as the proportion of dark traded-as-LIS blocks reached a record 28.7% on 12 January compared to 12% in January last year.

“LIS activity doubled last year and we think block trading will continue to grow this year,” adds Rosenblatt’s Puaar. “However, there is generally a natural ceiling to the proportion of trading done in blocks. The increasing number of block-trading venues means it may become even harder to match large trades.”

So have volumes moved onto lit venues as MiFID II intended? It would appear not, or at least not yet anyway, and as experts have pointed out, the introduction of DVCs will likely see firms consider the once-feared SIs as a genuine alternative rather than moving volumes onto lit exchanges.

There are similarities that can be drawn between BCNs and SIs, as BCNs were too often misunderstood and feared by market participants in the same way SIs are now. But there are other aspects to using SIs that are daunting to buy-siders; a lack of data and complicated reporting in particular, as well as a bad reputation following rumours of plans to circumnavigate MiFID II guidelines via a trading loophole.

The industry is mere weeks into the new regulatory landscape and any significant depth of change will not occur overnight. Metamorphosis on such a monumental scale will always throw up issues and teething problems are to be expected. Nevertheless, a tangible shift towards lit venues is certainly not happening yet, and with a flurry of new execution venues available under MiFID II which are struggling to provide coherent and granular data, it could be argued that the regulatory regime has in some ways created less transparency and more venues alternative to lit ones. 

Questions remain as to when, or indeed if, the buy side will fully embrace and adopt SIs as an execution venue. While periodic auctions are poised to continue growing, block trading activity will likely hit a roof at some point, leaving on-exchange as the last venue to see any tangible increase in activity. This could happen when the MiFID II RTS 27 best execution reports are made public in June. Although should that not come to pass, the industry can expect ESMA to revisit MiFID II’s rules around trading venues to make further adjustments. Just don’t mention MiFID III.