A SHIFT IN BALANCE OF RESPONSIBILITY.

Chris Hall explains how MiFID II will not only change the dynamics between buy and sellside but also the tools they will use to achieve best execution.

No matter when it lands, MiFID II is going to make a big splash in Europe’s dark pools. Not only will it drain many popular pools of liquidity, while revoking outright the licences of others, it will also force fishers to reassess their tools and their tactics.

“MiFID II is a catalyst for change and innovation, both in terms of liquidity matching and access tools,” says Adam Toms, CEO, Instinet Europe.

Over the past decade, buyside equity traders have settled into a routine when trading ‘institution-sized’ orders. Since slice-and-dice algorithms replaced worked orders by sales traders, thereby diminishing order sizes, the buyside has increasingly avoided the sardines and the sharks of the lit venues. Instead they trawl through indications of interest (IOIs) then lurk in the dark books of MTFs and broker crossing networks (BCNs) in hope of a big bite, either accessing pools directly or more often via an aggregation service or dark liquidity-seeking algorithm. If their luck is out, or their appetite is reduced, they might accept the risk of spreading their bait across multiple pools, knowing they are no longer in full control of their order, using a smart order router (SOR).

MiFID II will change how asset managers search for dark liquidity, not only by closing down BCNs and limiting the amount of trading permitted in dark MTFs below the directive’s ‘large-in-size’ (LIS) pre-trade transparency waiver, but also by placing more responsibility on the buyside for best execution and introducing greater separation between payment for research and execution services. These changes will expose poor execution quality to investors like never before, thus concentrating the minds of both brokers and buyside dealing desks.

“The biggest driver of change is the renewed focus on best execution. Buyside firms are taking their obligations under MiFID II very seriously, and some are viewing best execution as a source of competitive differentiation. Firms are re-examining their execution benchmarks, making greater use of TCA and examining venue toxicity levels ever more closely to navigate the dark liquidity landscape effectively ahead of MiFID II,” says Chris Jackson, European head of Liquidnet’s execution and quantitative services group.

Under the prevailing status quo, the level of European equity trading conducted in dark MTFs and BCNs has plateaued. According to Rosenblatt Securities, 11.64% was conducted in the dark in November 2013, rising to 12.13% in October 2015. Average trade sizes haven’t changed much either. The average size of trades executed on lit venues in Europe in November 2013 was €6,795, versus €6,842 in October 2015. The comparative figures for dark orders are €8,110 and €8,412 respectively.

However, Anish Puaar, European market structure analyst for Rosenblatt, predicts a frenzy of innovation as service providers look for new ways to meet the buyside’s proven appetite for avoiding market impact. “IOIs could be a particular area of innovation,” he suggests.

The SI conundrum

With BCNs banned, brokers are weighing up whether to register as systematic internalisers (SIs) or MTFs, to facilitate off-exchange crossing for clients, with the latter regarded as prohibitively expensive for most. All brokers have been holding their cards very close to their chests, in part due to uncertainty over whether the new rules will permit matched principled trading with clients in SIs, which would let agency brokers facilitate trades between clients without committing capital.

Regulated market operators – among them the London Stock Exchange, Deutsche Börse and BATS Chi-X Europe – have unveiled new initiatives designed to aggregate liquidity and facilitate block trading, but Puaar suggests take-up of such services may evolve only gradually.

“Regardless of the assurances the venues give on minimising market impact, the fact is you still need to rest a fairly chunky order on a book that can be accessed by all types of participant. Overall, the buyside is likely to become more discerning in how their orders are fed into the market. At present, there is still a tendency to direct orders to a range of familiar venues, but changes to best execution rules will compel the buyside to take a more quantitative approach to venue selection,” he says.

The need to be more specific in directing order flow could spur a new wave of innovation in algorithms, suggests Liquidnet’s Jackson. “Despite any future dark pool consolidation, as models evolve it will be even more important to navigate dark liquidity effectively. Dark aggregation algorithms must be able to control toxicity, enabling the user to decide when and how to expose their orders to other types of flow,” he says.

But if the buyside are going to stay in the dark, what kind of pools will they be fishing in? “We may see a bifurcation of the market in terms of liquidity sourcing,” says Toms, “with smaller child orders being internalised by electronic liquidity providers registered as SIs, potentially directly against the buyside, whilst block order flow is facilitated in venues that can deliver LIS liquidity.”

Buysiders can access Liquidnet’s MTF direct, where the average order execution size is US$1.5million, but the sellside can access alternatives. The Turquoise Block Discovery service, which matches undisclosed block indications and executes them in the Turquoise Uncross dark pool, reported an average trade size of E250,000 in October. In the same month, more than half of value traded via Turquoise Block Discovery was executed in greater than LIS size. By value traded since launch, Instinet accounts for 35% of all Turquoise Block Discovery trades.

According to global head of trading and securities financing Paul Squires, AXA Investment Managers directs larger, passive European order flow to Turquoise via a broker algorithm in search of block opportunities, before using SORs to access other sources of dark liquidity. “This reduces the intermediation of the broker in the order routing process, which is a key change in the relationship. Some buyside traders still struggle to feel sufficiently empowered to take that level of control, but I think it’s key going forward. You’re still selecting the most suitable algorithm for your trade, but you’re taking your own decision based on which venue you trust,” says Squires. AXA is also a backer of Plato, a not-for-profit dark platform that also aims to prioritise block liquidity.

Empowering the buyside

As dark pool operators review their strategies ahead, pressure is growing on the buyside trader to exert greater influence. Will Coulby, vice president, equity trading, JP Morgan Asset Management, says there will always be limits. “Clients and regulators are keen for asset managers to do more venue analysis in support of best execution. The quality of available data is improving and it helps to monitor broker performance, but it doesn’t give you the full picture, because you only see the completed fills. You never know if your performance in a particular pool is bad because of its toxicity or because of the order or conditions under which you interact with it,” he says.

The proprietary nature of broker SORs might be a barrier to better information, but not an insurmountable one. Finland’s Pohjola Asset Management Execution Services (PAMES) offers a neutral SOR, as well as an analytics capability to support better execution decision-making.

“Buyside firms should continue to improve their understanding of the impact of SOR logic on their execution performance. Asset managers should be influencing routing logic to get the best outcome for their particular trading style or strategy. But to do this, they need the ability to collate and analyse execution performance data, independently, across venues on a continuous basis. If you are small or don´t have the resources to do this, you might be better off outsourcing the trading function,” says PAMES CEO Simo Puhakka.

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