Pushed into the shade

By removing the trade reporting delay for large orders under MiFID II, the European Commission could push more order flow into the dark as the buy-side seeks to limit interaction with high-frequency trading firms.
By None

What effect will MiFID II proposals to shorten reporting delays have on high-frequency traders?

Market participants are concerned that, by reporting large positions sooner than at present, MiFID II will make it easier for high-frequency trading (HFTs) firms to exploit the positions of long-term investors or their brokers. This could drive up the cost of trading for long-only funds and push more of their orders into the dark.

How will it push up costs?

Risk trading, a preferred route for unwinding or building a large position will be made more difficult – and therefore expensive – under the existing MiFID II proposal. A broker has three days to unwind a large position under current rules. The suggestion is that under MiFID II, when the starting pistol sounds a broker should only have until the start of the following day to clear its book.

When a broker takes on the position of its buy-side client, the transaction is reported to the market as a principal trade. Due to their comparatively large size, reflecting as they often do an asset manager's entire position, the price, which by including the risk premium will be away from the market and the illiquid stocks in which they are typically made, these deals are conspicuous among both small algorithmic trades in large stocks and the small- to mid-cap stocks.

A sell-side firm that has not integrated risk management across its proprietary and client trading, or developed a risk system that allows hedging of client positions, will have to be quick off the blocks to minimise the market impact of acquiring the position.

Otherwise high-frequency trading firms would be able to exploit a broker's large position if it was reported to an exchange's post-trade tape soon after being acquired. That increases the risk involved in accepting such a trade for the broker and it will increase the risk premium accordingly.

Why would the shorter delay increase trading in the dark?

A buy-side firm building a large block in parts, as an alternative to high-cost risk trading, could find its strategy is identifiable by HFT firms, if some of its trades are reported before the position is fully accumulated, which would increase the market impact on the rest of its trades. As a result, asset managers are likely to favour trading in the dark to accumulate or unwind large positions. To avoid any exposure to HFT they could trade through broker crossing networks (BCNs), which are dark and allow segregation of order flow based on type.

Would that present a long-term solution?

Not really – in the EC's MiFID II consultation it suggested that minimum size thresholds could be introduced for dark orders to encourage transparency, supported by the European Parliament's adoption of a paper supporting that position in November 2010.

Although buy-side firms would rather trade in large size, the fragmented nature of the European market place means that breaking an order into smaller pieces posted across a range of venues increases the likelihood of a fill.

The EC has also suggested that BCNs would be reclassified as multilateral trading facilities if they reached a certain size, limiting the amount of business they could do without losing their ability to interact with order flow on a discretionary basis.

That said, the MiFID II proposals are not expected to be published until October 2011 having been delayed twice so far this year, so there is still time for buy-side firms to persuade the EC that the rules should be amended to reduce the impact on buy-side trading.

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