European regulatory proposals to implement a minimum size threshold for non-displayed trades could constrain choice and stifle innovation, according to new research from Credit Suisse.
The paper, titled ”One size fits none', suggests that market participants would react to minimum orders sizes by redistributing trades to a smaller number of dark pools. Credit Suisse created a series of ”what-if' scenarios based on how dark orders with an average size of US$17,000 would interact with eight dark pools models with volumes reflecting current market share percentages among European dark pools operated as multilateral trading facilities.
The study used a hypothetical order of US$150,000 (€102,000) – distributed across eight dark pools proportionate to the existing share of the current venues in the European dark market – to show the potential impact of minimum size constraints. The analysis showed that if a minimum order size of US$20,000 (€13,670) was applied to dark trading venues that employ MiFID's reference price pre-trade transparency waiver, market participants are likely to redistribute their orders to the three largest dark pools to avoid breaching the threshold. If the minimum size was set at US$100,000 (€68,370), the US$150,000 order could only sent to one venue, which the research assumes would be the dark pool with the highest market share.
Credit Suisse also looked at how the launch of a new innovative offering from a smaller dark pool would impact the market both with and without a minimum size threshold. The study found that an order size constraint would restrict the ability of the dark pool to hold on to any market share it gained as market participants would distribute orders back to the venue with the highest market share.
“According to our model, minimum order size constraints therefore stifle competition, increase barriers to entry and reduce the incentive to innovate,” read the report.
Using the same methodology, the research also examined the impact of a unilateral price increase by the largest dark pool venue. The results showed that a minimum order size would help the venue retain market share, again because orders would typically be redistributed according to where liquidity lies.
“If the intention of regulatory reform is a more efficient and competitive marketplace, then one-size-fits-all is not the best solution,” read the paper. “Our study concludes such an approach would dramatically reduce the size of the dark pool market, stifle innovation, increase costs and choke competition, with particularly detrimental impact on smaller sell-side firms and end investors.”
As part of its review of MiFID, the European Commission proposed in a recent consultation paper that all dark trades could be subject to a minimum order size to protect price discovery and encourage transparency. Final regulatory proposals on MiFID II are expected to be presented by the Commission by October this year.
Credit Suisse's latest research follows another report, ”Measuring dark pools' impact', released in February, in which the bank found no statistical evidence to show that price discovery for stocks was negatively affected by dark trading. It also found that small child orders traded in the dark could also achieve a significant level of price improvement.
According to Thomson Reuters, dark MTFs accounted for €21.25 billion worth of trading, representing a 2.5% share of overall European liquidity in May. This is higher than the €19 billion recorded in April, but lower in terms of overall market share (2.8%) because of increased European trading activity last month.