The decision from Brussels to push through a last-minute fix to its accidental loophole in dark trading regulation caused by a clerical error was, for many, an expected outcome. But the events have become a catalyst to an already ongoing, and at times heated, debate around whether the regulatory lens in Europe is focusing on the right areas.
Double volume caps (DVCs) were deleted as of 28 March in the original Mifir text published in January. However, the previous text only authorised the enforcement of the SVC [single volume cap] in 18 months’ time – leaving an unintentional window with no caps thanks to the clerical error. Brussels subsequently began exploring possible ways to close the loophole in the new share trading rules. In the last days of March, the European Commission subsequently rushed through a last-minute draft revision to its Mifir text to plug the loophole, keeping the DVCs in place until the implementation of the new single volume cap.
The regulator’s mistake and subsequent decision to fix it has re-sparked an existing discussion around why watchdogs are focusing their attentions on micro changes to regimes and not on the wider issue around low volumes in Europe – especially when the result has little to no impact on the markets.
Dark trading became the poster child of post-Brexit regulatory discussion in the UK and Europe, with the Bloc championing lit transparent trading throughout. The DVCs regime included in the January Mifir text had followed more than six years of deliberation over the desired cap on dark trading in the Bloc, with the European Commission and Parliament finally settling on the deletion of the 4% and 8% caps in favour of a single cap of 7%.
“In my opinion, the last-minute decision [in March] wasn’t a surprise as it’s been clear from the beginning of Mifid II that politicians and regulators across Europe are committed to the DVC mechanism,” Evan Canwell, equity trader and market structure analyst at T. Rowe Price, tells The TRADE.
An unintended experiment
Without the clarification, ESMA had the opportunity to stop enforcing DVCs until Q4 of next year. Had the last-minute changes to the text not come through, Europe would have found itself taking part in an unintended experiment to test how far dark trading could go if left uncapped.
“While I think it’s unlikely that ESMA had ever planned to stop enforcing the DVC mechanism during this period, it would have been a fascinating opportunity to observe the shift in market dynamics without any artificial constraints on dark trading,” adds Canwell. “This would also have allowed market participants and regulators to engage in discussions on both the optimal thresholds and the appropriateness of any future dark caps, in a fully data-driven manner.”
Following reports of the loophole in early March, participants and venues in some cases had begun to put in place contingency plans should dark trading be left uncapped. Those most vocal against the use of dark caps during the European regulatory discussions came from the buy- and sell-side, with many suggesting the new single cap of 7% was arbitrary and querying how the watchdog had reached this conclusion. Many were therefore keeping close tabs on the saga in March, watching the events unfold in the hope that what they considered an unnecessarily complex detail might not come to fruition.
“There was a genuine hope that there could be an opportunity for those caps to be repealed. I suppose intuitively you would expect a certain level of disappointment on a number of levels,” says James Baugh, head of European market structure at TD Cowen. “One is that we found ourselves in this position, but also perhaps that there wasn’t a willingness to use it as an opportunity, to provide that chance to see what would happen without the caps in place.
“If this was a mistake in the drafting, it would clearly take some courage to roll the dice to see what would happen if the caps were lifted for that interim period.”
The reality is that other regions where dark trading has been left uncapped have not seen the segment grow out of control. In fact, the US, which doesn’t enforce caps, and the UK, which ditched caps post-Brexit, have both seen dark trading reach a certain level and then plateau. In the UK, dark trading has peaked at around 13% of monthly traded volumes on exchange since removing its caps. Meanwhile in Europe, stocks are rarely close to the DVC thresholds.
“When we look at the double volume cap regime, it’s not like we’re seeing those European markets buffer at those levels,” adds Baugh. “It’s not like dark trading has got to those levels and therefore, it’s constrained at those levels. That’s not the case at all. If anything, the data would show you that it’s trading a couple of percentage points below those current levels.”
The market has evolved towards other forms of execution in light of the caps on dark trading, meaning a significant shift to dark venues is more than unlikely.
“There are a large number of well-established alternative venues (such as periodic auctions) which allow for trading in a ‘dark-like’ manner and have been firmly embedded in routing logic across Europe,” adds Canwell.
Why is it then that we have seen two major primary exchanges move to launch dark books in the last few months when it was those exchanges that were most against removing caps on dark trading during Mifid discussions? Both Euronext and Deutsche Börse have set their sights on dark trading in the last year. Euronext confirmed in May 2023 that it was set to launch a dark trading service. The service went live trading in March but has seen slow uptake as of yet.
This news was followed by rival exchange Deutsche Börse announcing own its plans to develop a midpoint trading functionality in March earlier this year. The new functionality has an envisaged launch of November. Known as ‘Xetra Midpoint’, the functionality is a customer-driven project according to Deutsche Börse and will be integrated into the Xetra market.
The events around the DVC correction when laid alongside the recent launches paint an interesting picture and begs the question: what is Europe trying to achieve? Europe as a region is one of the most fragmented markets to trade with three times the number of exchanges as the US, 10 times the number of listing venues and 20 times as many post-trade providers.
Central to many panels at recent events is the level of fragmentation Europe has reached alongside its comparatively low volumes to the rest of the world. While fragmentation is essential to competition, it can go the other way and harm markets by causing investors to widen the prices they show and reduce their size.
Speaking at a recent Bloomberg Intelligence event which explored ‘liquiditiy in transition,’ Eleanor Beaslety, COO, equity execution, Goldman Sachs, said: “Innovation is great and if something has a USP that brings more volumes into Europe, that’s great. What we don’t need is more of the same. There are a number of dark books. The interesting thing with primary markets is potentially they have unique liquidity in regions that are very national so that could lead to more liquidity coming to the fore. Where it’s just another venue, it’s expensive and it’s another overhead.”
Moving from a micro focus to a macro one
With volumes in Europe on a continuous decline – seen most drastically on the lit continuous order books – it forces participants to question whether or not regulators are focusing on the right areas, with many participants suggesting we should zoom out from these time-consuming micro debates and assess the wider macro landscape to support growth in Europe.
“We’re rarely in a steady state with regulation. We implement something and then months down the line we’re looking to change it,” said Anish Puaar, head of European equity market Structure at Optiver, also speaking at Bloomberg’s event.
“It’s every time something is introduced – e.g. DVC or SI thresholds – and this tinkering with micro aspects takes up a lot of time and doesn’t have any meaningful change in the market. Europe’s problems are much bigger than that.”
Volumes have indeed become increasingly segmented and internalised in light of the challenging volume environment in Europe. Alongside volumes executed by systematic internalisers, the bilateral and negotiated trade segments have also grown exponentially. This is where many suggest regulators should be focusing their attentions.
“That’s the bigger macro picture, not squabbling over the double volume caps,” says Baugh.
The UK is now bringing in new requirements in May that will transform the way firms tag trades and subsequently report them, shedding more light on volumes and liquidity taking place off exchange. However, a slight hinderance to this is that the UK and Europe have once again opted for ever so slightly different regimes.
“If we could flag OTC trades and get consistency across the UK an EU it would go a long way to solving a lot of what the consolidated tape is supposed to be doing,” added Rupert Fennelly, head of electronic trading sales and coverage, Barclays Investment Bank, also speaking at Bloomberg’s event.
The events of the last few months have exacerbated a desire from participants to see their appointed regulators re-focus their attentions on core structural issues surrounding Europe’s trading landscape. As a region, Europe must turn its attention away from the small and arguably arbitrary fixes in favour of a resolution to the larger issues at hand.
“We need to have some tougher conversations that might be politically difficult such as simplifying post-trade. That would be a much more meaningful debate than some of the tinkering we’ve done over the last 10-15 years,” concluded Puaar.