Will freedom for Europe’s dark pools achieve CESR’s goal?

One of the unintended – albeit anticipated – consequences of MiFID has been the impact of its pre- and post-trade transparency regimes on the price formation process.
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One of the unintended – albeit anticipated – consequences of MiFID has been the impact of its pre- and post-trade transparency regimes on the price formation process.

Allowing multiple execution venues to offer prices in the same European blue-chip stocks and then report the resulting trades at a variety of locations, while also creating a framework of waivers that permit ‘dark’ trading platforms to forego the publication of pre-trade quotes, was always going to alter the mechanics of how the best bid and offer for a stock is established.

In its April consultation paper on MiFID in the secondary markets, the Committee of European Securities Regulators (CESR) acknowledged that some “trading platforms and market participants consider that the use of [pre-trade transparency] waivers adversely affects the efficiency of the price formation process”. But rather than limiting waivers, price formation problems might be addressed more effectively by implementing a standardised and consolidated post-trade data feed and allowing greater flexibility in the application of waivers.

In its paper, CESR, which is responsible for securities market regulatory convergence across Europe, proposes a number of reforms to MiFID that would increase the share of trading on displayed markets, thereby bolstering public price formation. For example, the regulator suggests that the reference price waiver, which allows orders to remain dark if they are executed at a price sourced from a reliable reference market, may only be applied to orders above a certain size.

Plenty of restrictions to dark trading already exist. Currently, trading venues must operate separate dark order books to use the price reference waiver. This means the integrated dark and lit order books used by multilateral trading facilities (MTFs) such as Turquoise, BATS and Chi-X Europe are forced to use the large-in-scale price reference waiver, which only allows an order to be dark if its value is above a certain CESR-defined threshold. Furthermore, dark MTFs are only allowed to execute orders using the price reference waiver at either the mid-point, or best bid or offer price.

In its response to the CESR consultation paper, investment bank Credit Suisse noted that these two limitations have “the effect of creating a more fragmented and inefficient trading environment which ultimately disadvantages market participants and end-investors”.

Allowing systems that use the price reference waiver to execute anywhere within the spread and removing barriers to allow integration of lit and dark venues would, many argue, increase innovation, limit fragmentation and could result in a greater number of displayed executions. For example, an MTF that is free to execute anywhere within the spread and apply time-price priority across a combined lit and dark book would be able to execute a dark order on its displayed book if that is where the better price resides.

CESR has recognised that efficient price discovery and the ability to achieve best execution depends on market data from trading venues that is “reliable and brought together in a way that allows for comparison”. The regulator has taken steps to improve post-trade transparency by suggesting the creation of approved publication arrangements (APAs) and mandating a consolidated tape. Although some market participants wouldn’t want post-trade data consolidation to be prescribed in this way, it could be the only viable solution.

“The key benefits of a [mandated consolidated tape] would be easier price discovery, improved price and volume information for better execution and TCA (transaction cost analysis) data points. The lack of a consolidated tape makes it difficult for traders to get a complete picture of tradable liquidity across countries and trading venues,” wrote asset management firm Fidelity in its response.

A Brussels mandate will not be a silver bullet however. When CESR is still putting caveats on the data it uses to estimate off-exchange trading, the size of the post-trade data challenge is hard to overstate.

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