Buy-side advised to prepare for “restrictive” dark trading rules under MiFID II
Plato Partnership’s launch piece of research authored by Melbourne Professor of Finance, Carole Comerton-Forde, addresses the future of dark trading – any trading mechanism that does not have pre-trade order transparency.
With dark trading having increased from 3% to 8.75% between 2011 and 2017 (Rosenblatt Securities), thanks in part to the growth in high frequency trading, block and dark trading, MiFID II regulations on dark trading will have a significant impact on traders’ aims to source liquidity whilst managing costs and minimising information leakage.
Buyside firms utilise the flexibility of block and dark trading, however concerns regarding the propensity for dark trading which impacts price discovery and liquidity are widespread.
New regulations aim to enhance pre-trade transparency and force trade onto Registered Markets, Multilateral Trading Facilities and Systematic Internalisers. MiFID II limits reference price trades to midpoint, introduces double volume caps on the reference price and negotiated trade waivers at 4% of volume in a stock in a single pool and 8% of the volume in a stock across all dark pools, as well as altering the minimum size thresholds for Large-in-Scale (LIS) trades.
According to the report, “the dark trading rules that form part of MiFID II are the most restrictive compared to the US, Canada and Australia”. Certain changes, such as the narrower scope for the reference price waiver, pose fewer problems, however the report suggests that the impact of double volume caps, which can lead to the closure of dark pools for up to 6 months, will have a “dramatic and likely adverse effect on market quality”.
Responses to the most concerning change of the double caps are already in place, indicated in reports1 expressing an intended increase in the use of LIS waiver post-MiFID II. Consequently, there has been a growth in the number of initiatives, including LIS venues, new or modified order types facilitating LIS trades on exchanges, and high frequency and intraday auctions. However, concerns over market fragmentation are being raised.
The report makes four main recommendations:
· Buyside should assess 2017 trading levels to analyse the likelihood of possible 2018 trading suspensions;
· Collaboration between buyside and sellside to adjust operating practices in the case of dark trading suspension;
· Evaluation of the merits of new trading venues;
· Innovation in new technology to exploit new data to the buy-side’s advantage.
The advice to buy-side firms on the whole is to start “changing their behaviour now to ensure a smooth transition to the post-MiFID II world”.