The MiFID II Liquidity Landscape: Q4 2018

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MiFID II has now been in force for over a year and while implementation remains work in progress, the industry is successfully adjusting to the new liquidity landscape thus far. The challenge will be what lies ahead for the industry in 2019 given the indications from both regulators and politicians that further amendments to MiFID II are likely if current trading behaviours do not deliver the level of transparency required.

Dark trading continues to remain central for asset managers in reducing trading costs and delivering improved execution performance for end investors. While the introduction of the Double Volume Caps (DVCs) was less disruptive than first feared by some, liquidity did not return to lit continuous trading in the manner anticipated, but continues to fragment over a wider range of execution options, creating further challenges for the buy-side to uncover and access quality liquidity. These shifts in liquidity formation are set to continue during 2019 as the industry continues to evolve to the realities of MiFID II and even further potential change from the outcome of Brexit.

As DVC suspensions lifted in the last quarter of 2018, dark trading increased to 7% of overall market volumes; but as the proportion in the dark grew, the proportion traded Large-in-Scale fell. However, longer term trading behaviours are shifting as the responsibility to source liquidity sits increasingly with the buy side trader along with the obligation to evidence best execution. As a result there is a greater propensity to trade blocks wherever possible which has seen the proportion of large in scale trading maintained at ~36% of dark volumes compared to 10% in 2016*1.

The emergence of new methods of execution such as periodic auctions continued to rise in the first half of 2018, stabilizing at circa 2% of the market. Some buy-side concerns remain in relation to the levels of broker preferencing and transparency as demonstrated in Liquidnet’s report *2. As a result, ESMA’s call for evidence on periodic auctions, launched in November 2018 *3, signals the likelihood of further regulatory change.

Systematic Internaliser activity initially increased substantially in the first half of 2018 reaching €15.8bn. However, since August the amount executed on these venues has decreased to an average of €6.5bn in November and December. This drop in activity coincided with a continued fall in the average fill size from ~58.9k EUR in April to ~21.7k EUR in December. In the second half of 2018, the executed notional is down by 31% for interactable SI activity and 46% for non-interactable liquidity. This is likely due to improvements in classification of true SI activity reducing noise in the SINT tape, as well as brokers realigning the level of capital available within SIs as the success of individual business models become apparent. With the European Commission’s recent amendment *4 to subject SIs to the tick size regime for standard trade sizes and restrict their ability to price improve, liquidity formation within SIs is also set for further change.

The political uncertainty surrounding Brexit and the future relationship UK/EU27 will also impact the likelihood of further legislative change. There is still a question mark on whether the UK Parliament will ratify the Withdrawal Agreement in a vote expected to take place the week of January 14th. With the EU unwilling to re-open negotiations to provide legally binding clarification on the temporary nature of the backstop, both the UK and EU have accelerated their “no deal” contingency planning ahead of March 29th and the risk of liquidity splitting between the UK and the EU27 remains, ultimately making markets more fragmented and less efficient.

Political events will continue to make their mark on European markets this year. The European elections are scheduled to take place in 2326 May, and the European Commission and the European Council terms are also coming to an end with replacements expected to be in place in the second half of 2019. With political deadlines fast approaching, legislative efforts are intensifying; The Investment Firm Review (IFR) looks to limit cross-border access of third country firms into the EU while the European Supervisory Authorities (ESA) Review *5, proposes greater controls over third country venue access by putting in place a “reciprocal requirement” for the equivalence determination. The political outcome of Brexit along with the IFR and ESA review could dramatically change the direction of travel for EU Capital Markets paving the way for continued regulatory change in Europe under the guise of MiFID III. While the industry has successfully adjusted to MiFID II, no-one can remain complacent for what lies ahead in 2019.

By Rebecca Healey & Charlotte Decuyper, Market Structure & Strategy, EMEA, and Gareth Exton & Joe Fields, Global Execution & Quantitative Services

The data discussed in this introduction are taken from the charts set out in the following pages unless states otherwise
1 Shape Shifting: Accessing the Dark Post MiFID II. Liquidnet, December 2017

Ellen Gordon