Is the fragmented European market consolidating at last?
In the lit market perhaps, but the number of unlit venues is increasing. Part of this is driven by regulation, but there also appears an increased appetite from buy-side firms to trade in the dark, which brokers and exchanges are hoping to profit from.
In its proposals for MiFID II, the European Commission (EC) has suggested that broker crossing networks which are accessible to flow from third parties, or that reach a certain level of trading volume, should be classified as multilateral trading facilities (MTFs). A consultation on its proposals will close on 2 February, with the final recommendations planned for release in Q2 2011. But prolonged European legislative processes mean MiFID II won't become law before 2013.
Ahead of that, some brokers have decided to launch MTFs, typically citing commercial rather than regulatory reasons, often to complement their crossing networks. Nomura and UBS have set up MTFs on this basis, while Goldman Sachs plans to go live before the end of Q1.
How many new MTFs could we be looking at?
It is hard to say. Citi Match and Credit Suisse's Crossfinder are the largest dark pools in Europe but they may remain supported by proprietary as well as client flow. Citi has said it has no intention of turning Citi Match into an MTF and Morgan Stanley, which operates MS Pool as a broker crossing network, is believed to be waiting for the regulatory outlook to become clearer. BarCap's LX broker crossing network is currently in customer testing. Many other sell-side firms such as J.P. Morgan and Société Générale also operate crossing networks and Royal Bank of Scotland has announced that it will launch its own, RBS Cross, in Q1 2011 to be used for client and proprietary crossing.
Is it only block trades that are traded in dark pools?
No. Increasingly there are two types of dark trading, large block trades and their small fragments, i.e. trades that have been sliced up to access liquidity across venues. In November 2010, the average trade size on buy-side only crossing network Liquidnet in Europe, according to US boutique brokerage Rosenblatt, was over €1 million. Agency broker and technology provider ITG's POSIT dark pool by comparison had the second largest average size, at €18,393, while MTF BATS Europe Dark had the fifth largest average trade size with €9,299. Increasingly dark trades are being carried out for reasons other than preventing market impact. Research provider Celent carried out a study with Goethe University of Frankfurt in September which found that the share of OTC trades that would face no market impact in the lit market increased from 68% in 2008 to 80% in 2010 for highly liquid shares and from 58% in 2008 to 66% in 2010 for less liquid stocks.
According to ITG, which has carried out a number of studies on the costs of trading in the dark, for orders of non-large cap US stocks, which exceed 200% of the median daily stock trading volume, crossing networks provide the lowest costs and the greatest opportunity to fill orders. In Europe, ITG found that execution costs for an order in a lit MTF are 43% higher than in dark venues and for exchanges costs are 71% higher. It estimates the risk of price slippage to be 41% higher in MTFs and 92% greater on an exchange than in the dark.
So should we expect more dark trading?
Clearly brokers think there is enough room for more offerings. Although comprehensive information across all dark trading channels is not readily available, bald statistics suggest dark trading has grown at an incredible rate. Data vendor Thomson Reuters' Equity Market Share Reporter shows that from November 2008 to November 2009 turnover grew from €1 billion to €9.2 billion and in November 2010 hit €18 billion. During the same period volumes in the lit market were relatively flat.
It has been notoriously difficult to calculate the volume of European trading that takes place in the dark. Broker crossing networks were not categorised under MiFID and so they were not subject to the same reporting rules as other venues, such as regulated markets or MTFs.
Because trades that take place off-exchange are not required to be tagged with the details of the venue on which they have executed, and because the methods of tagging that do exist are not yet standardised, measuring the amount of trading that occurs on unlit or OTC venues is difficult, and analysis of trading performance is impeded. For example some trades may be counted and reported by both buyer and seller, giving an inaccurate total figure. In its consultation on MiFID II, the EC has proposed that a system of flags be introduced for OTC trades to identify where an execution takes place which would improve the situation.
Several attempts have been made to put a figure on the size of the OTC market. The Celent / Goethe University of Frankfurt study put the size of OTC trading at around 40% of the total market, while analysis by global broker Nomura puts the figure at less than 10%. A study by ITG released in Q2 2010 said that trading on alternative venues accounted for 35% of the European market, 16% on dark venues.
What are the implications of more dark trading?
In November 2010, the European Parliament's ECON committee adopted Welsh Conservative member of European Parliament Kay Swinburne's ”Regulation of trading in financial instruments: dark pools etc' paper, which recommended that all broker dark pools be classified as MTFs and that executions in the dark should be subject to size restrictions. According to single market commissioner Michel Barnier, the paper is serving as informal guidance for the EC in its review of MiFID. If politicians and regulators are worried about trading in the dark now, a growth in volumes is likely to increase their anxiety.