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Traders Turn to the Dark Side as MiFID II Spotlights Liquidity

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A report by Liquidnet highlights the impact of MiFID II on trading behaviour in Europe, including a rise in large-in-scale (LIS) block trading in dark pools, periodic auctions and systematic internaliser (SI) volumes, as traders hunt for liquidity.

The ‘Buy-Side Perspectives Survey: Post MiFID II’ is based on interviews with 58 heads of trading and dealing across Liquidnet’s member network of asset management firms throughout the UK and Europe during April 2018, in a bid to measure the impact of MiFID II regulation on buy-side liquidity capacity. The answers suggest some surprising results.

Although the goal of MiFID II is to increase transparency with a focus on lit price formation, the need to execute in size is in fact pushing asset managers further towards institutional-sized dark orders in the hunt for liquidity. Some 88% of firms registered the shift towards LIS dark trading as a positive outcome of the regulatory reform. Despite the introduction of double volume caps (DVCs) as a means to limit dark trading, the introduction of new alternatives and the widely used LIS waiver mean that just 19% saw DVCs as negatively impacting performance.

Almost 70% of respondents also cited periodic auctions as a benefit of MiFID II following the introduction of DVCs, although around 50% warned that further regulatory updates could be required. Some 50% of firms also support the implementation of a minimum order size in periodic auctions, while 49% suggest a minimum pre-matching period based on the liquidity of an instrument. And here too, transparency ambitions have faltered, with just 12% believing that MiFID II has increased the level of volume transparency in periodic auctions.

SIs have also increased their share of block liquidity above the level of previous broker crossing networks (BCNs), as their usage ramps up in advance of the new SI regime coming into force in September 2018. This has delivered mixed results for buy-side firms, with survey respondents warning of a potential market imbalance due to an increasing appetite for risk from banks translating into a rise in SI activity.

Uncertainties over interpretation of the SI regime also remain. Over two-thirds (65%) of participants believe they can choose whether their broker routes to its SI or onto the open market, but the remaining 35% are still unsure of routing practices given their inability to monitor broker routing effectively.

Rebecca Healey, head of market structure at Liquidnet EMEA, says: “Lit markets operated by exchanges offer a wide range of order types, some of which are designed to attract high-frequency trading. This potentially creates a challenge for the buy-side trader. The argument for trading institutional-sized orders in the dark is a clear one, to protect the end-investor from negative market impact due to unnecessary information leakage. However, the argument for trading sub-LIS orders in the dark may be just as valid for those asset managers looking to improve execution performance for a portfolio rebalancing or when facilitating institutional crosses. The reality is that asset managers need multiple methods of execution available given the variety of orders, differing market conditions, and execution objectives required. Hence the rise in use of periodic auctions and SIs as alternative methods of sourcing liquidity.”

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