What price transparency?

Politicians are keen to inject greater transparency into equity markets by getting rid of broker crossing networks, but whether their MEPs' MiFID II proposals will yield the intended benefits remains to be seen.

Recent news coverage suggests MEPs are determined to outlaw broker crossing networks (BCNs). What do they hope to achieve? 

Quite simply politicians want to put an end to what they consider to be a less-than transparent, and, some might say, underhand practice that allows banks to match client and proprietary flow internally, on their own terms and without paying the costs associated with regulated markets.

Discounting for the moment motives of post-crisis vengeance on banks, policy makers are driven by a desire to inject greater transparency into financial markets in the belief that this will revive investor confidence. When it comes to transparency, dark pool operators have not always helped themselves. BCNs do not quote on a pre-trade basis and reported trades are mixed in with OTC data, giving a hazy picture of their activity at best. In May 2010, six banks attempted to shine a light on BCN activity by reporting aggregated turnover on a daily basis via Markit BOAT, but this done little to appease regulatory concerns.

It’s worth noting that the BCN issue has been on MEPs’ radar for sometime. Kay Swinburne MEP said in her 2010 own-initiative report on the MiFID review that “the absence of sufficient regulation for … BCNs provides a competitive advantage to the OTC space and encourages an increase in trading in the dark, undermining market transparency in general.”

Is it BCNs that MEPs want to eradicate or all dark trading? 

While some would like to go back to the fictional period in which all trading was done on exchange, other MEPs strike a slightly more pragmatic note. Fewer opportunities to trade in the dark means, in theory at least, liquidity will naturally migrate to displayed markets, or at least those with clear guidelines on pre- and post-trade transparency.

This is nowhere more evident than in the Economic and Monetary Affairs Committee’s recent amendments to MiFIR (the regulation accompanying MiFID II) which proposed cramming as much OTC equity trading as possible into systematic internalisers, a (much derided if misunderstood) category of venue created by the directive’s first version. MEPs also proposed restricting the organised trading facility, a category of venue introduced by the European Commission to capture BCNs, to non-equity instruments only. This would force BCNs to become MTFs or systematic internalisers.

More trading on regulated markets and a commitment to minimising OTC trading – which accounted for 43% of European trading in March according to Thomson Reuters – will improve price formation across European stocks, say politicians.

Though growing, the proportion of European equity trading conducted by BCNs is believed to be only 3-4%, so the impact on price formation of closing down these venues would appear questionable.

How much attention have MEPs paid to the buy-side’s generally positive assessment of BCNs? 

Not that much really. But there is at least an acceptance that institutional traders need a differentiated source of liquidity that offers them the opportunity to trade in size and mimimise market impact. But MEPs insist that MiFID already addresses this issue adequately.

The original directive allowed trading venues to forego the publication of pre-trade quotes as long as executions fulfilled certain criteria, such as being over a certain size or transacted at the mid-point. While buy-side traders make good use of the dark pools that utilise pre-trade transparency waivers, the increasing prevalence of high-frequency trading (HFT) in these venues has led the buy-side to make greater use of safer environments like BCNs, where they can exert greater control, in terms of selection of trading counterparties.

Is a reduction in buy-side choice inevitable? 

The buy-side may have no other option but to use dark multilateral trading facilities (MTFs) or systematic internalisers as their only method of limiting market impact if the MEPs are granted their wish of no equity trading beyond MiFID’s three existing venue categories. In addition, MiFID II could restrict systematic internalisers to only allow crosses against proprietary flow and may require pre-trade quotes, which could limit their effectiveness.

This debate is far from over though, with the Council of the European Union, formed of representatives from national governments, yet to have its say.

But brokers have been monitoring regulatory developments for some time and are past masters at adapting to regulation. Even if MiFID II takes a hardline approach to dark trading, who would bet against a rebirth of the BCN in another form?

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