The MiFID II Liquidity Landscape: Q3 2018

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One of the key regulatory objectives of MiFID II was to restore investor confidence in European Capital Markets through improving pre-trade price transparency. To achieve this, the double volume cap mechanism (DVCM) was introduced under MiFIR in March 20181 to limit trading under the reference price and the negotiated transaction waiver. Post the first expiry of DVC suspensions on 622 instruments, there has been limited impact in moving trading back to the lit; dark trading accounted for 6.8% of total market volumes in September compared to 5.8% in August 2018 (see Exhibit 1). There are approximately another 100 instruments that will see thresholds lifted mid October which is likely to increase dark volumes still further; but trading behaviours have already altered. The proportion of dark trading that is large in scale now stands at 40% (see Large-in-Scale chart) vs 10% in 20162; and liquidity has fragmented over a wider selection of routing options with levels of activity adjusting accordingly. Periodic auctions, seen as an alternative to non-LIS activity post the introduction of the DVC, have now decreased from almost 3% to 2% (see Liquidity Overview chart) of the market in September; while systematic internalisers and Dark MTF activity continue to grow, with blocks becoming a more dominant proportion of dark trading.

Investor confidence in European markets is not only influenced by regulation, but by being able to successfully enter and exit an investment strategy. The ability to trade directly impacts European citizens’ pension and savings plans as well as the capital raising processes of European governments and companies, to reduce their cost of funding, and the ability to trade in the dark remains central to asset managers ability to help investors, companies and governments achieve these investment objectives. The question is what will the regulators opt to do next to address the perceived issue of a decline in lit market trading and the subsequent impact their action will have on European Capital Markets as a result.

Crossing at mid-point between the bid and the ask is understood and accepted globally as a fair execution price which is widely used by both institutional and retail investors as savings can be significant. While certain regulators see the ability to cross at mid as a disadvantageous to lit primary venues and not contributing to price formation; from our research, asset managers tend to disagree. The ability to trade at mid-price limits any unnecessary adverse market impact and reduces market volatility by synchronising of buy and sell order flow over time periods - what is considered “temporary” market impact. The volume traded at the mid still contributes to overall market volumes.

Pegging at mid also contributes to price formation through fluctuations in price during the the auction process. Firms can also ensure a fair execution without the need to enter ‘LIMIT’ orders which would require consistent manual updating to ensure the right price is achieved, which would be both inefficient as well as prone to error. Not all auctions offer the same functionality, and some do have a higher proportion of “fading”, where clients pull back and cancel their orders, not contributing to true price formation and similar to negative market interaction on lit primary exchanges.

In an attempt to reverse the decline in lit market trading, further regulatory intervention is likely. ESMA’s recent consultation paper on Article 49 and RTS 11 of MiFID II3 plans to extend the minimum tick sizes for equities and depository receipts to all orders including limit orders resting on an order book, orders held in an OMS and LIS orders pegged to the mid-point in a lit order book. They have also announced their intention to publish a call for evidence in the coming months on the potential use of periodic auction systems to circumvent the DVC regime. The MEP Markus Ferber has outlined plans to ensure all SI activity should be subject to the proposed changes to the tick size regime, irrespective of the order size. Although ESMA note that the tick size regime would not apply to matching orders under the reference price and negotiated trade waivers4, buy-side concerns remain. If half tick executions are no longer viable, a situation could occur whereby mid-point is only possible on an even tick spread and not an odd tick spread, as this would result in a half-tick execution price.

The regulatory and political focus on shifting trading back to lit primary markets fails to understand the underlying reasons why asset managers prefer alternative methods of trading away from national exchanges. The level of innovation at certain European exchanges is seen by some as minimal and not directed towards protecting institutional order flow but is focused instead on increasing data revenues.

Multiple studies demonstrate that the most expensive place to trade is at the touch on the lit primary market, where the beneficiary is the market maker, increasing the cost of trading for the end investor. A recent speech from the SEC highlights that the for-profit structure “gives exchanges every reason to structure stock markets in a way that maximizes their rents. And every time exchanges raise prices, that money comes out of investors’ pockets, who pay more to buy and sell stocks than they otherwise might. The elaborate stock-market structure we have today isn’t free.”5 Firms’ MiFID II best execution obligations mean they have a fiduciary duty to review all execution options available to them and trade where they can achieve the best execution result for their end investors taking into considerations all implicit and explicit costs. Rather than regulate against dark trading activity, periodic auctions and SI, the buy-side argue that differentiating factors will naturally influence the selection process and ultimately the success or failure of different order execution models.

Whatever the final outcome of the latest regulatory proposals, any further constraints on alternative methods of execution could have significant implications for overall liquidity formation in Europe post-Brexit. The more onerous and costly trading in the EU becomes, the more market participants are likely to seek alternatives to trade such as switching from a direct equity ownership model in Europe to trading swap in UK. While this would be a sub-optimal outcome in terms of liquidity formation, potentially leading to a rise of intermediaries and arbitrage, ultimately whichever jurisdiction can offer the lowest cost to trade and deepest liquidity pool will be successful. ESMA are calling for a harmonised EU regime for third-country trading venues under MiFID II to limit the effects on the markets of a no-deal Brexit arising from the impact of MiFID II calculations performed at the EU level, such as the double volume cap (DVC). This includes preparations for memorandums of understanding (MOUs) between EU national competent authorities (NCAs), as well as ESMA, and their UK counterparts before the end of March 20196.

At the 11th hour, some form of equivalence between UK and EU regulators is likely to be reached, with a transition period to December 2020 which both parties will buy-in to avoid a market crisis. But regulators should take heed, the creation of a more onerous regime in the EU27 could ultimately result in liquidity returning to the UK and be counter-productive to the future development of CMU, shifting the liquidity landscape in European markets once again.

Rebecca Healey, Head of Market Structure & Strategy, EMEA, and Gareth Exton & Joe Fields, Global Execution & Quantitative Services

1 https://www.esma.europa.eu/double-volume-cap-mechanism
2 Shape Shifting: Accessing the Dark post MiFID II, Liquidnet, December 2017
3 https://www.esma.europa.eu/press-news/esma-news/esma-publishes-responses-its-consultation-proposed-amendments-rts-11
4 https://www.esma.europa.eu/sites/default/files/library/esma70-872942901-38_qas_markets_structures_issues.pdf
5 https://www.sec.gov/news/speech/jackson-unfair-exchange-state-americas-stock-markets
6 https://www.esma.europa.eu/sites/default/files/library/esma70-156-787_wfe_speech_steven_maijoor.pdf