News & Views

Traders fear EU rules will cause stumbles in the dark (Financial News)

APPEARED IN THE FINANCIAL NEWS JANUARY 2017

Financial News reported on Liquidnet's survey The New Dark Age by Rebecca Healey, Liquidnet's Head of Market Structure & Strategy in Europe. Rebecca surveyed buyside traders responsible for $13.5 trillion and found worries over implementation of Europe's new trading rulebook next year

Liquidnet surveyed buyside traders responsible for $13.5 trillion and found worries over implementation of Europe's new trading rulebook next year

New rules are set to transform stock trading in European dark pools in less than a year's time, and buyside traders are worried.

Liquidnet, a global operator of dark pools, found a mood of nervous anticipation when they surveyed some of Europe's most senior traders, who oversee the buying and selling of stocks at fund management firms looking after $13.5 trillion.

Liquidnet canvassed 53 Europe-based global heads of trading during August 2016. The firm has compiled the results into a 28-page report, authored by Liquidnet's head of European market structure Rebecca Healey, entitled 'The New Dark Age' and seen exclusively by FN.

Dark pools, trading venues often run by large banks, are so called because they keep each trader's bids and offers secret from others.

They are highly-valued by investors as they allow large orders to be placed free from detection, and avoid exchange fees. In Europe, they account for around 10% of all stock trading activity, according to analysts.

But European regulators are concerned too many smaller orders are placed in the dark. Because dark pools always take prices from public, or lit, exchanges, if too much trading happens in the dark the public price may not be a good reflection of all buying and selling activity.

So starting in January 2018, the amount of trading taking place on the venues will be capped, though waivers will exclude larger orders from these limits. Furthermore, the rules will force brokers to restructure the dark pools they run, meaning more regulatory oversight.

Healey said that institutional investors were having to "reassess how, where and why they trade in the dark" and here's what she found.

The dark still matters...

Buyside traders are in no doubt of the multiple benefits of trading in the dark. Among the respondents to Liquidnet's survey, 66% said they used dark pools because they improve liquidity; 64% said they reduced the market impact of trades, and 51% valued the anonymity.

Being able to trade in blocks (large orders) was another key benefit, cited by 45%.

One trader told Healey: "The benefits of the dark are zero market impact, trading inside the spread, improved liquidity—but really it's that our orders are now so large that we need to trade dark to get into positions that our portfolio manager actually wants to buy."

However, another trader added that "we now have clients coming in saying we don’t want any interaction with dark pools".

Confidence in bank-run dark pools remains high

Dark pools have come under intense regulatory scrutiny in recent years, with fines even levied against investment banks (which tend to be known as brokers when trading) in the US and Asia.

Healey said the operational integrity of dark pools was less of an issue in Europe, and found that 81% of buyside traders were confident, or reasonably confident, with the operational structure of dark pools.

However, almost half of the respondents said they were concerned by "internal preferencing", whereby brokers first route client orders to their own dark pool to find a match.

One buyside trader interviewed by Healey said: "When on-boarding, [the] first thing we ask [the broker] is how much you internalise. Red flag is internal preferencing and alarm bells will go off at anything over 13-15% of flow."

And more than a third (36%) said they were not confident in external routing practices - or brokers' procedures for sending trades outside their own trading venue.

Healey said these concerns were "often based on a perceived lack of detail rather than hard evidence of wrongdoing".

So, what does the buyside want from brokers?

For nearly half (49%) of the buyside dealers questioned, transparency was what they needed from their brokers.

Healey said: "For many, a lack of transparency, even opacity, remains synonymous with many dark pools. Some firms feel stonewalled by their brokers, frustrated by partial answers to questions about how their orders are being handled, under the guise of proprietary information."

In addition, better data and analytics (28%), execution and market structure consultancy (23%) and information flows (21%), were also highlighted as important considerations when selecting a broker.

How well are traders prepared for Mifid II?

Mifid II, which comes into force on January 3, 2018, will significantly restrict dark pool trading, primarily through two caps, both based on the value of trades in a stock in the previous 12 months. No single dark pool must account for more than 4% of trading in a stock in that period. Across all dark pools, the level of dark trading in a stock must not exceed 8%.

The European Securities and Markets Authority will monitor trading to ensure the caps aren't breached, using data submitted by the banks and other trading venues. Breaching the limits means the stock will be banned from trading in the dark for six months, and the counting has already begun to meet the 2018 start date.

When asked what contingency plans they had in place if the caps are met with the first few days of Mifid II, 45% of respondents said they would adopt a "wait and see" approach.

Nearly half, or 43%, said they would trade large-in-scale orders, the market term for block trades, where possible. Under Mifid II, the rules are not changing for these orders, which can take place off-exchange with full anonymity provided they are of a sufficiently large size.

Only 11% of the investors said they would trade on the lit, or public market.

One buyside trader said: "It's in nobody's interest if we can't trade in the dark."

Return of the block...

There has already been a steady increase in LIS, or block-trade activity, as a proportion of all dark trading. On dark-pool multilateral trading facilities, it has increased from 9.2% in the first quarter of 2015, to 11.5% during the third quarter of 2016, according to Liquidnet.

However, this means blocks still represent a small proportion of dark trading, which itself is a small proportion of overall trading, raising the question of how exactly investors will match larger orders.

One unnamed buyside trader said: "Brokers still design algos [automated trading algorithms] so they don't trade in blocks unless that block is going to trade in their own pool. We need to stop playing games if we are to get the liquidity we need."

Healey added: "If firms are to use the LIS waiver, we will need to see a fundamental shift in institutional trading behaviour away from using algos to break up a block to instead keeping as much of the parent order as possible intact."

…but no silver bullet yet

Dark pools have been trying out various ideas to make block trading easier. But Liquidnet found no strong consensus among investors on their merits.

Conditional order types, whereby a block order is traded in smaller sizes until a matching order is found, were the most popular of the new ideas, with 29% of respondents saying it was their preferred option. The Turquoise Plato Block Discovery system uses this model.

Periodic auctions, adopted by Bats Europe whereby auctions are run continuously throughout the day, were preferred by 24% of respondents. Auctions, which traditionally take place at the open and close of trading, by their nature lessen the incentive for smaller, faster trades and encourage larger orders.

But mid-day auctions, such as that adopted by the London Stock Exchange, were "perceived as having the least value", according to Healey.

One trader said: "The midday auction is a joke, frankly - I don't understand it from a valuation point of view."

So what's the future of bank-run dark pools?

Mifid II will require brokers (banks) to register their dark pools as either a systematic internaliser (SI) or multilateral trading facility (MTF), or else shut down.

MTFs are quasi-stock exchanges open to all market participants, whereas a bank using its own capital to facilitate trades - by buying shares from a client who wants to sell, and then holding them in hopes of finding a buyer later, for example - will be regulated as an SI, provided they hit certain thresholds.

Given MTFs have a high implementation cost and allow no control over access, many brokers expect to become an SI, Healey posited. Brokers will automatically be treated as SIs if they account for more than 1.5% of the market in a given stock.

But three quarters of the respondents said they had either received insufficient or no information from brokers as to how their dark pools will evolve into SIs. Only 13% said they were comfortable with broker SI proposals, with 12% saying they had seen SI plans, and were not comfortable.

One trader said: "Investment banks are not the best venue owners. Independent, non-conflicted models will claw back market share."

Nevertheless, nearly a quarter (23%) of Liquidnet's buyside respondents said they plan to use broker capital via an SI as their intended method of dark execution under Mifid II.

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