The historic focus on dark trading instead of actually publishing prices has made a mockery of authorities’ ‘transparency’ concerns. Dan Barnes reports.
MiFiR, Europe’s reform of MiFID, offers it the chance to break free of lobbyist goals to subvert market transparency, and support best execution for investors.
“The whole point about best execution is the outcome,” says Paul Squires, head of trading for EMEA and APAC equities at Invesco. “We have to try and achieve the best outcome for our clients.”
While ‘best execution’ is enshrined in the MiFID text, its rules have in fact confounded it in practice. For example, since the 2010 review of MiFID I, regulators in Europe have been actively working to reduce the level of dark trading as a proportion of total trading. They imposed double volume caps (DVCs) on dark trading, which takes place without counterparties publishing the prices they are trading at.
In 2018, MiFID II imposed the cap of 4% of the total amount of a stock to be traded without pre-trade data disclosure on any platform within the EU, and an 8% cap for dark trading for any given stock. By exceeding these caps, any firm would be banned from trading the stock on any dark pool for six months.
The stated objective of regulators was to ensure that market transparency was supported effectively by ensuring the pre- and post-trade disclosure of trading information.
At the same time, European regulators failed to put in place a post-trade tape of pricing information which would immediately deliver transparency on trading activity. It had been in place in the US since 2005 when Reg NMS required all broker dealers to report their best bid/offer to Securities Information Processors (SIPs).
Squires notes that this concern about lit and dark trading is not one that exercises investment management firms.
“If it happened that lit primary exchanges were the best place to trade, we would do 100% of our business on primary lit exchanges,” he says. “Equally if dark pools were the best place to perform 100% of our execution, we’d do it all there, we have no axe to grind. So, people have rightly asked why regulators even tried to intervene in lit versus dark trading.”
In 2022, a draft report on MiFIR, published by Danuta Hübner, rapporteur for the Committee on Economic and Monetary Affairs (ECON) at the European Parliament, concluded, “The cap mechanism limiting dark trading under these waivers should be suspended. These caps were set arbitrarily and proved to be of limited utility, and their removal would reduce complexity and align the Union with international practices.”
Natan Tiefenbrun, president of CBOE, speaking at the FIX EMEA Trading Conference in March 2023, said, “Regulation must put the needs of investors and issuers to the fore. It needs to be pro-competition and not for any subset of competitors. I think, unfortunately, in Europe there has been a degree of regulatory capture where intermediaries and exchanges have – not alone – historically influenced regulation to favour their business model with their best interest… My plea would be for much less regulatory intervention and any that we do have should be explicitly pro-competition.”
A potted history of lobbyists and MiFID
The story of lobbyists’ intervention in European markets began in 2007 with MiFID I. Its objective was to push down explicit trading costs charged to sellside firms by trading venues, through increasing competition. It made no consideration of implicit trading costs, such as the expense of aggregating market data from multiple venues trading the same security. The lack of any standardised reporting model such as a consolidated tape, meant that buyside firms found it difficult to make like-for-like comparisons of the execution quality provided by brokers.
“MiFID I opened competition of venues which is overall positive, but a slight negative is, with so many venues, that has fragmented liquidity,” says Squires. “We don’t have a consolidated tape so we don’t have that Reg NMS [best execution metric] that the US have. So it provides challenges, that’s for sure.”
The open-endedness of MiFID I’s language turned Europe’s markets into an uneven playing field, with equity trading fragmented across all sorts of venues, some lit and some dark, some broker-run and some exchange-run. Venues could avoid regulation by structuring themselves so they did not fall into the defined categories of multilateral trading facility (MTF), regulated market or systematic internaliser. Consequently, they had no obligation to report their trading or market participants.
By allowing over-the-counter trading to occur on venues, without providing a regulatory regime for them, MiFID I allowed unregulated crossing networks to pop up which further obfuscated the picture of liquidity and price in the equity market; they were not subject to the same reporting requirements as MTFs, regulated markets or systematic internalisers. Incumbent national exchanges found order flow moved to the low-cost MTFs and crossing networks.
The exchanges felt that many of their rival venues were unfairly advantaged by their lack of regulatory supervision. Competition rose, trading fees fell, lobbyists and European authorities were up in arms about the sellside operating unregulated trading venues.
Subsequently regulators put rules in place which reduced dark trading, but did not build a consolidated tape mirroring the US model. While firms whose commercial interests lay in selling data delayed and obfuscated the value of the tape, investors have carried 16 years of costs to aggregate data at the time of going to print.
Putting investors first
Hübner’s 2022 review went directly and critically against this historical approach, and was voted for on 1 March 2023 by ECON, giving it a greater likelihood of being adopted into law.
The Association of Financial Markets in Europe (AFME) issued a statement in response noting that in light of the agreement, it was optimistic that the MiFIR Review can be concluded under this legislative term.
However, it took issue with the continued approach to managing aspects of trading which it observed stood out from other regulatory regimes.
“On equity market structure issues, we have consistently argued in favour of reducing complexity and safeguarding investor choice across equities trading mechanisms as this allows for cheaper and more efficient execution to the benefit of end investor returns,” said Adam Farkas, chief executive of AFME. “The ECON’s approach to restrictions on certain trading mechanisms, such as volume caps and limits on execution sizes and mid-point trading, impede investor choice and best execution. These features remain at odds with international practices and risk contributing to the continued decline of the EU’s attractiveness as a global capital markets centre.”
With Britain and Europe now beginning to diverge on market regulation, it will be imperative that an objective view of the investor goals for best execution are maintained on both sides.
“There are definitely some differences appearing now between regulators towards assessing best execution, but MiFID II was established when the UK was in Europe, so there was a harmonised and core set of rules and principles which essentially remain undiminished so there aren’t significant differences,” says Squires.
He notes, “What is difficult to avoid is the fact that, post-Brexit, there are political considerations. While the market doesn’t care for political considerations, it’s very obvious that they are coming into play.”
The level of impact that any changes may have will largely be based upon the resources that a given investment firm can put into managing the complexity created by market structural change.
“We are pretty forensic about transaction cost analysis (TCA),” Squires notes. “I think the ability to deliver best execution across all of the different venues is more about your own capabilities than it is about European market structure,” he adds.
