Staring into the dark

Broker dark pools have been under threat since the start of regulatory negotiations on MiFID II, but clarity on final rules is likely to be some way off.

Why does MiFID II need to address dark trading?

Since the term ‘dark pool’ was first coined, the practice of off-exchange trading has come under renewed scrutiny, with regulators and market participants questioning its impact on price formation. 

Dark pool detractors argued the practice of trading without displaying pre-trade prices beforehand risked making stock prices less reliable.

Those fears have been quelled, largely due to the relatively small proportion of trading activity that is transacted in dark pools.

But regulators and politicians have now set their sights on the various models of dark pool available, specifically broker crossing networks (BCNs).

BCNs were designed by investment banks with the aim of internally matching client orders, sometimes mixed with proprietary trading flow. Brokers have discretion on how they match orders, enabling them to find the best match for their clients and are able to avoid trading venue charges.

So why are regulators suspicious of BCNs?

For a start, MiFID didn’t strictly allow the creation of BCNs. Brokers shaped their BCNs using the definition of OTC trading, i.e. trading conducted on an ad hoc and irregular basis.

This means BCNs are currently subject to a different regulatory regime compared to regulated markets and multilateral trading facilities, despite essentially offering a similar service.

For example, BCNs are only labeled as OTC trades in post-trade data, while venues such as Turquoise and BATS Chi-X Europe are identified as dark multilateral trading facilities (MTF).

BCNs are also allowed to pick and choose who accesses their venues and how orders are matched, raising concerns the venue type encourages a two-tier market restricting access to liquidity for some investors.

How will MiFID II address the issue?

It is still unclear and the issue has dominated discussions between policymakers, with banks and exchanges lobbying hard to get their views across. While the buy-side does not have the same lobbying force as its sell-side or exchange counterparts, it has constantly voiced a preference for a variety of trading venues to meet its execution needs.

The end-game for BCNs will either be a reclassification of the platforms under existing MTF or systematic interaliser categories – an approach favoured by MEPs on the European Parliament’s Economic and Monetary Affairs Committee – or they will fall under a new organised trading facility (OTF) designation.

The European Commission initially created the OTF category, and reiterated its suitability, for housing BCNs, while the Council of the European Union – which is currently conducting its own assessment of MiFID – also favours the use of OTFs for equities if they don’t include proprietary trading.

Have there been any MiFID II proposals that would change the way other types of dark pools operate?

There has been some discussion on the pre-trade transparency waivers that dark pools use to keep trading interest on their platforms anonymous.

The initial version of MiFID created three waivers that included: orders over a certain size, bilaterally negotiated transactions and orders that reference the mid-point price of a stock from its primary market.

The mid-point reference waiver – used by the majority of dark MTFs – is being looked at by regulators, with the latest Council draft proposing that this waiver also be subject to a minimum order size of €6,000. The European Commission has adopted a similar stance, but the final model for this waiver is far from certain.

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