Rule-makers caught out in the dark

New rules introduced by MiFID II and a pan-European transaction tax could have far-reaching implications for dark trading in Europe, while US authorities are expected to review critical regulations that impact alternative trading venues.

By None

Is the OTF venue category in MiFID II going to be a game changer for accessing dark liquidity in Europe?

Very likely. Final details for the organised trading facility (OTF) due to be enshrined in Europe's updated regulatory regime, MiFID II, are far from completion, but seem certain to have far-reaching effects for dark pools. The version of MiFID II agreed upon by the European Parliament late last year would exclude broker-operated dark pools for equity trading from the OTF category and require them to be regulated as a multilateral trading facilities (MTF) or a systematic internalisers.

Although the Council of the European Union has yet to finalise its position on MiFID II, a draft document circulated by the Council in February suggested it had decided to include all asset classes under the OTF category. However this same MiFID II draft banned the use of proprietary capital in OTFs and stated that matched principal trading - i.e. client facilitation trades - should only be used for OTFs that trade non-equities. This would drain broker-operated dark pools of a lot of their current liquidity and have a detrimental impact on their crossing rates.

The Council is expected to reach a final position in June, and the trialogue process - where the Council and Parliament negotiate a final text with input from the Commission - will likely begin after summer. According to such a timeline, a final MiFID II will not emerge until early into 2014, with implementation slated for 2015.

Will the wave of financial transaction taxes (FTTs) in Europe create further regulatory uncertainty for trading in the dark?

France and Italy have established financial transaction taxes and a pan-European FTT is in development. The French FTT taxes trades in securities of Paris-listed companies with a market capitalisation of €1 billion or more - just over 100 companies. The Italian tax, which came into force in March, differentiates between lit and dark activity, levying a high tax on dark trading.

The French tax saw a dip in trading volumes that has since stabilised, while the Italian tax has had a more evident impact with lower volumes seen across lit and dark venues. The Italian FTT 0.12% on exchanges and MTFs and 0.22 on broker dark pools (dropping to 0.1 and 0.2 respectively after 2013) and brokers reacted by arranging the terms of trading in their dark pools and executing and reporting them on a registered exchange as negotiated trades. This type of reaction from market participants, which was somewhat unprecedented from the regulators, may occur if and when the 11 European states supporting a regional FTT implement a tax.

Although an implementation date of 1 January 2014 was initially set by the states supporting the tax, insiders have conceded this is optimistic. The 11 states are currently discussing the details of the tax, based on a draft from the European Commission, which would see equities trades - including those in dark pools - taxed at 0.1% if the pool in question was within one of the 11 member states, or if it traded an instrument issued within one of the states. This means a German stock trading on a UK-based dark pool would be subject to the tax.

What kind of regulatory uncertainty exists in the US and what changes are expected in the near future?

The Securities and Exchange Commission (SEC) last week stated it would likely perform a wholesale review of Regulation National Market System, or Reg NMS, in the near future. While this specific piece of regulation does not directly govern dark pools - which are drive in large part by Regulation Alternative Trading Systems (Reg ATS) - proscriptive rules for trading on-exchange within Reg NMS have dictated a steady flow of liquidity to dark pools.

In particular, the rule within Reg NMS to offering sub-penny pricing only for stocks under US$1 facilitated a growth in dark trading as market participants saw this spread as too wide for higher-priced stocks. If the SEC allowed sub-penny pricing for all stocks, exchanges may see an increase in liquidity as some activity migrates back from dark pools.