Big can be beautiful, brokers are discovering as they consider how to respond to MiFID II’s limits on dark trading
OK, so MiFID II (sequel subtitle: the exchanges strike back) has restricted the forces of darkness, but will not kill them off completely. What kind of off-exchange trading will be possible in Europe come 2016-7?
In broad terms, broker crossing networks (BCNs) will no longer be permitted. These will have to be turned into dark multilateral trading facilities (MTFs) or systematic internalisers (SIs). Several brokers that currently operate a BCN have not yet decided which way to jump. If you think you add most value by facilitating client-to-client crossing, you’re better off as an MTF, which is designed for universal access and common rules to all participants. If you want to offer clients the opportunity to cross against your own flow, such as transactions generated from your derivatives franchise, you will be looking to switch to SI status.
MiFID II also restricts how much trading can be conducted on dark MTFs. No more than 4% of trading in a given stock can by traded in any individual dark MTF that uses either the reference price or negotiated waiver. And no more than 8% of trading in any stock can be conducted in such venues collectively. Dark MTFs that use the large-in-scale waiver are not subject to any restrictions, reflecting the central aim of politicians to only permit off-exchange trading for those few large transactions for which market impact can be regarded as a more pressing priority than price discovery.
Much is yet to be decided. How the limits will be implemented and policed is subject to Level 2 rules to be framed by the European Securities and Markets Authority, as are any changes to the large-in-scale waiver to further stimulate block trading.
So dark pools, as we know them, are on their way out. What happens to the orders that the buy-side have been happy to trade on the dark side until now?
It’s fanciful to suggest that all those trades that are too small to leap the large-in-scale threshold will find their way back onto lit exchanges. That liquidity will more likely just ebb away. To prevent this, BCN operators are examining their options.
Trading in the dark is only a means to an end of course. Algorithms have enabled market participants to slice up trades into ever-smaller order sizes over the past decade or so, in both lit and dark venues, in the interests of reducing market impact and achieving lower trading costs. But, partly under regulatory duress, the market is rediscovering the idea that big can be beautiful. Brokers are looking afresh at ways of aggregating liquidity in a way that increases trade size but not footprint.
Societe Generale for example has introduced a service that allows clients to choose their counterparties, which is encouraging them to trade in larger size without fear of being gamed. Bank of America Merrill Lynch is looking to introduce to Europe functionality already used in the US which matches conditional buyers and sellers on an automated basis at the mid-point. While technology plays a key role in aggregating liquidity and generating block trades, the human touch is also making a comeback. Goldman Sachs’ Contingent Crossing helps clients complete block trades by allowing a sales trader to step in when potential matches arise in a firm’s electronic order flow.
Many on the buy-side will certainly welcome an increase in block trading opportunities. But can they be sure brokers are operating in their best interests?
Most buy-side firms take a ‘trust and verify’ approach, these days. It is ultimately their fiduciary duty to the end-investor to ensure that brokers’ order handling processes are as cost-effective as possible. Detailed questionnaires from individual firms and collective initiatives such as the FIX Trading Community’s work on transaction cost analysis and venue tags on messages underline this. And most sell-side firms seem to have got the message that transparency is a critical part of broker selection criteria. ITG, for example, recently introduced a page on its website dedicated to transparency, which provides video clips and other materials to show clients how the broker-dealer’s algorithms, order router, analytics tools and of course dark pools operate.
If things get any clearer we’ll have to stop calling it dark trading.