Equitable Treatment in Equity Markets

Deutsche Bank’s Stephen McGoldrick underscores the complexity of the MiFID Review proposals for trade delay reporting and minimum order size and suggests a way forward.

MiFID Review: An equity market fit for all?
Deutsche Bank recently responded to the European Commission’s Consultation on the MiFID Review. While there is much to applaud in the proposals, the bank made it clear that we are concerned about some of the detailed proposals and, perhaps, more concerned about the lack of both detail and justification provided for others.

Protecting All Retail Investors: Not just the wealthy
The consultation process has raised a fundamental concern around what the review is seeking to achieve. Policy makers want, to varying degrees, to increase investor protection and the orderliness, stability and efficiency of the market. It is an unfortunate truth that the promotion of one of those goals may be at the expense of another. There will be trade offs the regulators are willing to make, but knowingly providing investor protection for a small group of retail investors at the expense of a larger less wealthy group of individuals is surely not one of them. Yet, by designing a market structure to serve those who are investing in the markets directly, the regulators may reduce the returns of the millions of individuals who invest via collective pension and saving schemes. The interests of retail investors must be protected explicitly and carefully, and doing so includes providing them with efficient markets that can handle their order profile.

Somewhere, however, we seem to have lost sight of the fact that “retail flow” (i.e those small orders sent to the market by private individuals) accounts for a tiny proportion of the flow from retail investors. Most individuals investing in equities access the market collectively.

Equity markets could, in theory, be optimised for retail flow but we believe that serving the relatively low numbers of individuals who have enough time and wealth to speculate directly in the market, at the expense of the far larger numbers who rely upon the wholesale market to manage their investments, would be a gross disservice to those prudent enough to save and cautious enough to do so via investment managers.

Trade Reporting Delay Proposal: Harming the retail saver
It is a broadly accepted principle of equity markets that, in general, trades should “print” as soon as possible to help inform the price formation process. There is also a broadly accepted exception to this principle, namely that the reporting of the largest of wholesale trades should, under certain circumstances, be delayed. However, it is proposed that both the duration of such delays and the number of orders qualifying for them should be massively reduced. The only rationale for these changes that we can find in the Consultation Paper is the truism that it “would help to make post trade information available sooner to the market”. Although it would, to many market practitioners it is equally clear that it would also reduce the investment returns of collective retail investors, while increasing the cost of capital for the Small-Medium Enterprise sector that so much else of the proposals rightly seek to support.

Example of the negative impact of small orders in lit order booksSo why might a European Member of Parliament support this proposal? It appears that the desire to achieve a level playing field between individual retail investors and collective retail investors has led some to the view that if delays are of no benefit to the former, they should be denied to the latter. The irony is that the harm done to the returns of collective investment  schemes by these proposals would not benefit individual retail investors, but rather the lost returns would be collected by high frequency strategies run by market professionals that seek to trade ahead of large orders.

Minimum Order Size: A Counterproposal
The review proposes to have a minimum order size in dark pools. We can see no benefit and multiple disadvantages to this proposal, and as no benefit is described in the European Commission’s consultation paper, we cannot comment on whether it would be an effective means of achieving the underlying policy objective. Such a change should not be made unless there is a “greater good” that justifies both the loss of price improvements that the retail investors currently accessing these pools would suffer and the commercial advantage that such a proposal would bring to the operators of lit books to the detriment of the operators of dark books. A better proposal would be to protect retail investors from the harm done to the market by large investors trading in an unnecessarily small size in all pools. If artificially small orders are prohibited by regulators, they will be promoting improved efficiency, market orderliness and price formation.

Such a ban would:

  • Improve Price Formation: Small orders in lit books distort the pretrade price when they narrow the spread. Users of the market data see a move in their reference price that is disproportionate to the value of the order that has created it. This may be best demonstrated by an example [See insert box].
  • Reduce the Cost and Increase the Value of Market Data: The widely used Level 1 data from lit venues shows only the best bid and offer. A minimum order size would dramatically improve the usefulness of that data and would better inform the market of trading intentions. At present the published price is often meaningless when it appears in a very small size, indeed many users have to buy the far more expensive, and difficult to use, Level 2 data to allow them to look beyond the best  price to find the first tick with relevant size.
  • Improve Reference Price Quality: Those trading in dark pools that use the reference price waiver would gain confidence that the lit price being referenced was in a material size and thus more valid as a reference.
  • Reduce Market Data Volumes: A reduction in market data volumes would help to reduce the growing infrastructure costs and risks of transporting the ever expanding volume of data.
  • Increase Post Trade Efficiency: Regrettably, some of the infrastructure in Europe has costs that  accrue on a per fill basis. Efficiency would be improved if participants were prevented from breaking their order flow into uneconomically and artificially small pieces.

It is important to be clear that this is not a proposal to adopt a “round lot” regime, nor do we seek to prohibit genuinely small orders from entering the markets. Thus, if an investor’s whole size is below the limit, then it would be admissible, perhaps with the constraint that it cannot narrow the lit spread.

One Size Does Not Fit All
There are those who would push the equity markets toward homogeneous execution on lit books. Some proposals seek to do this by reducing the viability of existing alternate approaches rather than by improving the quality, and hence the attractiveness, of lit books. Such an approach can only reduce the overall efficiency of the market. It is unrealistic to think that many different types of  investors, each with their own trading strategy and time horizon, can be catered to by one single style of order execution.

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