By: Will Winzor-Saile, Execution Architect, Redburn
There is no escaping MiFID II. As the regulation becomes clearer and industry consensus forms, every financial firm is working hard to be ready for January 3, 2018. Alongside implementation, myriad discussion papers address the challenges faced in the new world – where can we trade dark, how will we transaction report, how do we reach millisecond clock precision? Yet few focus on the upside for the industry. This level of regulatory upheaval will have far-reaching implications – some positive, some negative – but, whatever the outcome, we know there will be change, and change connotes opportunity.
Eucalyptus regnans is a species of tree native to Tasmania. It is one of the tallest trees in the world. Like many trees growing in crowded forests it is locked in eternal struggle with neighbouring plants, each aiming to grow higher and capture more light than its competitors. Each tree is forced to find new and innovative ways to survive. In one such example, when a eucalyptus is faced with a forest fire, it releases thousands of seeds onto the ground. The fire clears the landscape, giving the seeds space to grow in freshly fertilised soil. Many other plants take a similar approach and within a few weeks the forest floor will be covered with new life.
Major regulation has a similar effect on financial markets. By forcing firms to change the way they trade, it reshapes the marketplace. Although some firms are inevitably harmed in the process, it offers opportunities for growth and encourages innovation from both incumbents and new participants. While (as with forest fires) the result is not always positive, the change it wreaks is essential to ensure a healthy, active ecosystem.
The end of dark trading
A great example of this, and one of the most debated elements of MiFID II for equities, has been the introduction of double volume caps. The volume of trades performed under certain pre-trade transparency waivers – effectively, any small trades performed on dark pools or multilateral trading facilities (MTFs) – will be capped at 8% of the volume in that stock across the whole market, or a 4% share for any single venue. If the cap is breached, no dark trading (under the relevant waivers) will be allowed for six months.
Without the correct flags, or consistent reporting, it is hard to estimate how many trades would fall under these waivers today. Taking the FTSE All Share as an example, it has been estimated around 15% of trades by volume take place in the dark. We can debate the value of this share, which trades to include, and how many stocks this means would hit the cap, but one thing is clear: many stocks are likely to hit the cap. When that happens, as far as the regulator is concerned, there is no more trading in the dark.
With the end of dark trading as we know it, firms are forced to look for alternative ways to trade. The rationale for establishing dark pools remains – the buy-side needs discreet ways of trading large blocks with minimal information leakage – and, thankfully, regulation allows for alternatives.
ESMA has chosen to restrict the dark caps to a specific subset of the available waivers, in the hope of encouraging the use of those not covered. Primarily, the ‘large in scale’ (LIS) waiver – any trades with a value over a certain threshold (€15,000 to €650,000 depending on the stock) are excluded from the caps and can be traded without any limitations. This means natural crosses put together manually by a broker, or block executions on a venue, can continue, even if smaller executions must move to other venues.
Of course, the dark is not only for block trades. For example, if you are trying to hit a benchmark over the day you might slice smaller orders out to the market at each point but still wish to benefit from price improvement. Thankfully, the definition of ‘dark’ remains as vague as ever. Although dark pools and MTFs are caught by the caps, the Systematic Internaliser (SI) regime – around since MiFID I – is considered lit by the regulators and therefore does not have the same restrictions. With an SI, you can no longer trade at the midpoint, but you can potentially generate material price and size improvement over that shown in traditional lit markets.
The SI model is likely to appeal to many participants. Anyone who crosses a large proportion of their business off-exchange will be forced to register as an SI. So, for large investment banks, it will be essential to register to continue doing business. Registration includes an obligation to publish quotes. How far they go beyond the basic obligations, however, will depend on their business model. On one hand, they may choose to publish the widest quotes in the smallest possible size to ensure they never trade. On the other hand, it becomes a new market making strategy as an extension of an existing central risk book. In this instance, quotes can be adjusted to build or unwind positions as needed and incorporated into existing strategies to reduce trading cost.
In contrast, electronic liquidity providers (ELPs) are already generating actionable quotes throughout the day, sending these direct to exchanges or MTFs. The SI regime offers them a great opportunity to interact directly with their clients and cut out the middle man. This is not great news for MTFs that rely on their flow today, but with support for tiered or client-specific prices, the ELPs have the chance to operate more complex models and provide better prices for more trusted clients.
The combination of these factors is likely to cleave the volume trading in the dark into distinct factions, with MTFs evolving into block-only venues and liquidity from broker pools separating between the broker’s own liquidity and external providers. With each player moving in a different direction, these areas offer plenty of scope for new participants and innovative trading models to arise.
Fighting fire with fire
In response to these changes, we are already seeing a rise in new ways of accessing liquidity. More venues now support contingent/conditional orders that allow you to post the same order in multiple venues at once. As a result of lobbying from primary exchanges, auctions have also been excluded from the dark caps. This has triggered an explosion of intraday auctions, periodic auctions, auctions on-demand – pretty much any type of auction imaginable. This trend looks set to continue and, while not every idea will stand the test of time, the next 18 months should prove incredibly complex and fast-moving.
While major changes in the landscape are driven by liquidity venues, the knock-on effect for the rest of the market is clear. Whether buy-side or sell-side, the only way a firm can keep pace is to match this speed and level of innovation. This, of course, has been known for years. As Leon C Megginson observed in 1963 when considering Charles Darwin’s On the Origin of Species: “It is not the most intellectual of the species that survives; it is not the strongest that survives; but the species that survives is the one that is able best to adapt and adjust to the changing environment in which it finds itself.”
As market changes develop, each firm must take a view on which aspects are most important and will provide the best results for their style of trading. Some firms will choose to focus on scale, selecting a strategy that provides the best results for the majority of orders, while others will specialise and tailor the liquidity to each individual order. Both approaches have their advantages, but no matter your style of trading, something will need to change.
Back in 2009, when Redburn launched one of Europe’s first dark aggregators, life was relatively simple. There was a clear distinction between what was traded in the dark (on an MTF or broker dark pool) and what was traded in the lit (on an exchange or lit MTF book). As things have progressed, these lines have become blurred almost to the point of meaninglessness.
Taking the SI regime as an example, is it dark or lit? As far as regulators are concerned, the operator has pre-trade transparency obligations, so these are lit venues. Yet from a broker perspective, your order is never visible on the order book and does not impact the published volume, therefore it must be dark.
Even the impact from trading with an SI will change dramatically from venue to venue. Whenever you trade with an SI, the operator is trading as principal and taking on a position that, sooner or later, it will need to unwind. If it does this slowly over the day, your trade will be almost invisible; if it is unwound immediately, the market impact could be the same or worse than if you had hit the lit market.
So, are SIs dark or lit? In truth, it does not matter. Once again, it devolves to understanding the profile of each venue and what the objectives of your order are – whether minimising market impact, executing quickly, finding the best price or avoiding information leakage. Only by understanding the way each venue works can you properly navigate the landscape.
A new way of thinking
While the liquidity venues are fighting to stand out and gain market share, and the brokers are keeping up with the flood of new venues, what is the buy-side up to? Aside from dealing with a raft of new obligations around trade and transaction reporting, it has important decisions to make.
Between commission unbundling and a greater focus on transaction cost analysis (TCA), MiFID II is encouraging a more transparent, data driven approach to trading decisions. This is no surprise, given the rest of the world has been investing in machine learning, complex event processing, big data and hundreds of other buzzwords. Many aspects of financial markets remain behind the curve.
The amount of additional data passed through the trading life-cycle under MiFID II is set to increase dramatically. This poses challenges around latency, storage and data security, but represents another opportunity for participants to understand their trading to an unprecedented degree.
Capturing, storing and analysing all the data is a huge task, understanding the data is even more difficult. Once again, it is tempting to over-simplify, categorise venues and brokers into broad buckets and compare using basic benchmarks. This might seem like a quick win, but it loses the subtleties of each order and the qualitative aspects of trading – service, agility and trust are ever more important as the number and complexity of markets continues to grow.
A cautionary tale
Although Eucalyptus regnans relies on forest fires as an important part of its growth and development, it can also be responsible for causing them. Known as the ‘stringy gum tree’ for good reason, the leaves and bark contain high quantities of oil, which makes them highly combustible – around 70% of energy released from Australian wildfires comes from eucalyptus. Moreover, the trees cannot withstand the fires they create, owing to the absence of a lignotuber, meaning even well-established trees can be lost.
The parallel in financial markets is clear. While innovation is accretive for the industry, it must be treated with caution. MiFID II provides an unprecedented breeding ground for new ideas, new venues and new ways of trading. It has the potential for huge improvements, but no-one is too big to fail and badly directed innovation can be almost as bad as no innovation at all. At best, this could lead to swathes of restrictive legislation, at worst, the failure of a long-established firm.
Always look on the bright side of life
Following a fire, no-one can know exactly which plants will survive, which will thrive and what new growth will appear, but we still have a good idea of how the forest floor will look. With MiFID II, we know dark trading will change, existing pools will evolve into MTFs or SIs and they will use a wider variety of methods to avoid the dark caps. These will include large-in-scale and negotiated trades, and auctions.
Although dark trading will remain, as these new venues and order types emerge, the landscape will become increasingly complex. The effort to understand and navigate this new world is huge, but it also provides a huge opportunity for better, more efficient trading.
MiFID II has been crafted with admirable intentions: to increase transparency, improve price discovery and create more efficient markets. However, it is the unintended consequences that offer both the real excitement and the real danger.
Inevitably, there will be negative impacts that will require more thought and, no doubt, another round of regulation in a few years’ time. However, the innovation driven by these ongoing changes will have a much greater impact than the regulations themselves and that must be positive for the industry.
Bring on MiFID III.
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