"Arbitrary" Dark Pool Caps Leading to Increase in Block Trading and Innovation

One of the more contentious elements of Mifid II, the restrictions on the use of dark-pool trading waivers, will ultimately lead to more technology innovation and large-in-scale (LIS) or block trading, according to panelists at this year’s TradeTech conference in Paris.

The double-volume cap states that the use of two waivers, the reference price waiver and the negotiated trade waiver, will be subjected to limits — 4% of European trading on any one trading venue and 8% of European trading on all venues as a whole.

“Dark trading is one of the areas that has been spectacularly misunderstood by the regulators throughout the whole Mifid II process,” said Richard Semark, managing director of equities at UBS and CEO of UBS MTF, referencing the Financial Conduct Authority’s thematic review of trading, which found that dark-pool trading was popular with buy-side firms due to its effectiveness.

“What we are moving into is a situation where the effective ways [of trading] are being constrained by the regulators,” said Semark. “As a result, we are seeing innovation as a way to maintain the ability to trade in a way that suits the investment processes of buy-side clients.”

Ralston Roberts, co-head of electronic trading for EMEA at Goldman Sachs, agreed with respect to the value of dark trading, stating that the regulation was pushing institutions away from the “natural medium,” which could “lead to unintended consequences,” namely that it would create future trading environments that regulators had not envisaged in terms of price discovery.

Arbitrary

There has been significant criticism from across the industry against what is seen as a limitation on interactions between buyers and sellers to mutually agree prices. The levels at which the caps have been set have been singled out in particular as a ruling that many in the industry are unable to comprehend.

Rob Boardman, CEO of ITG Europe, described the 4% and 8% cap levels as “arbitrary” and a “political compromise,” pointing out that both dark and block trading have low levels of market impact and that the dark markets will have to evolve as a direct result of the rule.

“Plain and simple, there will be new types of platforms, which are ostensibly lit, like systematic internalizers or periodic auctions, and that, combined with the execution above the LIS waiver, will become the [new] dark market,” Boardman said.

Meanwhile, Semark said that the caps were a result of lobbying by incumbent exchanges, reflected in Mifid II, which would ultimately result in a move away from dark trading, either via electronic dark pools or voice dark trading, onto lit exchanges.

“What we will see is innovation in terms of allowing trading, which would normally take place in an OTC manner, being moved to on-exchange,” he said. “What is disappointing is that the innovation is about trying to pull existing behavior into a regulatory framework, as opposed to developing ways people want to trade.”

Game Theory

Both Semark and Ralston admitted that their respective institutions were adopting a game theory approach — the study of participants’ behavior in strategic situations — to the impending caps as industry data and volumes show that both caps will be breached soon after January 3, 2018, if not on the first trading day of the new year. 

“We think that most people will cap out,” said Ralston. “It is very hard to dial back. I don’t think it’s possible for everyone to work together on this. There are a handful of stocks that will never reach those caps, so there will be a place for dark trading in multilateral trading facilities (MTFs).”

The expected outcome of the double-volume caps is that liquidity will become further fragmented over the course of the next 12 months and there has been an increasing demand from the buy side for more tools to increase its level of control, especially as asset managers go in search of greater returns in block-trading venues.

“We’re seeing the magnetic approach that large-in-scale trading has,” said Semark. “But we shouldn’t underestimate the behavioral change that is required; it requires considerably more patience, particularly from portfolio managers. I think we will see a growth in LIS, but there needs to be an education process through to portfolio managers about how that method of trading is better but slightly different from what they’re used to.”