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WorldJuly 1 2013

European Council leaves buy-side in the dark

A compromise proposal brokered by the Irish government would limit the proportion of EU equities traded in unlit venues. But critics say it is unnecessary and unworkable.
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What’s happening?

The European Commission proposed texts for the second Markets in Financial Instruments Directive (MiFID2) in October 2011. The European Parliament voted through its amendments to the texts a year later. Following disagreements among member state governments, in May 2013, the Irish government – which holds the rotating EU Council presidency until June 30, 2013 – presented a compromise text.

This new compromise proposes capping trades on unlit trading venues – so-called dark pools, where the prices of individual trades are not displayed. No individual unlit venue would be able to host more than 5% of trades in any given EU-based instrument over the previous rolling 12-month period, and all dark trading in any given instrument must stop if unlit trades constitute more than 8% of the total volume on a rolling 12-month basis. These suspensions would last for six months in both cases. Block trades in sizes above a certain threshold (yet to be decided) would be exempt.

Do we need it?

The thinking behind the EU’s move is that dark pools undermine pre-trade price transparency and liquidity in the markets, consequently driving up costs for end-users on the buy-side. But this is hotly debated. In June 2013 alone, a study by Nasdaq and the Australian Capital Markets Co-operative Research Centre concluded that “dark venues are damaging to overall market quality except for the execution of large transactions”, while an academic paper by Haoxiang Zhu at Sloan School of Management in the US concluded that “adding a dark pool alongside an exchange tends to concentrate price-relevant information into the exchange and improve price discovery”.

Equally disputed is how much trading actually takes place in unlit venues. A study by the Federation of European Stock Exchanges in 2009 came to a figure of 40% of trades, whereas the Association of Financial Markets in Europe, using the same definitions of dark trading, responded with one of just 12%.

How would it work?

With extreme difficulty. Regulators cannot even agree on how to define dark trading, and consequently cannot measure how much trading is conducted on unlit venues. Individual broker trading venues (UBS Pin is Europe’s largest) do not make information on their trading volumes available, while official multilateral trading facilities (MTFs) that subsequently report their trades only account for a small part of total volumes.

According to Steve Grob, director of group strategy for trading technology company Fidessa, only 5% of stocks on the FTSE100 UK stock index would have breached the 8% individual instrument limit over the past 12 months based on MTF trading alone, but that would rise to 20% if broker networks and negotiated over-the-counter trades were included. This lack of precision would also make the rules relatively easy to circumvent.

“Japan outlawed dark pool trading altogether, but off-exchange trading still goes on, and is reported as negotiated trades to the Tokyo Stock Exchange. We could see exactly the same kind of development in Europe if this proposal goes ahead,” says Mr Grob.

Moreover, the measurement of the trading thresholds will rely on the development of a single consolidated tape in the EU for post-trade reporting. Yet this process has been stymied by a lack of agreement between technology vendors and exchanges over data provision.

Reg rage - exasperation

What is the alternative?

There is a general consensus that the real battle is between exchanges and broker networks, which have mushroomed since exchanges were demutualised and began to ramp up fees for their members (and former owners). Third-party MTFs and their buy-side clients are being caught in the lobbying crossfire.

“MiFID arguably allowed unlit trading – the reference price waiver – not only for large orders, but for any order that would suffer the same negative effects if exposed in the lit markets. That could be a smaller or less traded stock, or a trading pattern or strategy by a particular asset manager which might become visible in the lit market,” says Juan Pablo Urrutia, European general counsel of Investment Technology Group, which runs Posit, one of Europe’s largest MTFs.

He warns of possible “pandemonium” if investors suddenly lose access to certain trading venues for six months on a rolling 12-month basis. Other policy-makers who have focused on best pricing for retail investors have suggested an obligation for retail orders to show price improvement to justify the use of an unlit venue.

“In an area where policy-makers have shown themselves particularly adept at suggesting half-baked proposals, a price improvement obligation is perhaps the alternative that could limit and contain the damage that the 8% universal cap will otherwise inflict on market structure,” says Mr Urrutia.

In the back of every market participant’s mind is the knowledge that MiFID1 took eight years to agree and implement. The EU policy-making process is not flexible enough to respond if the dark pool cap proves unworkable.

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