MiFID II’s Unintended Consequences


By Gianluca Minieri, Deputy Global Head of Trading, Amundi

Connectivity between communities and venues is the key to exploiting the scale, breadth and the depth of the European trading market.

When in 2007 the European Union (EU) regulators decided to implement Markets in Financial Instruments Directive (MiFID) I, they did it with the intention of laying the foundation for a comprehensive, single regulatory framework for European financial markets, which would help develop and enhance market-based funding of European economies.

The main principle underlying the legislation was that the European economy was getting insufficient funding from the financial markets due to the high cost of transactions, such as commissions charged by trading venues. According to this theory, these transaction costs were impeding the development of secondary markets, which, in turn, could be detrimental to market liquidity.

The primary purpose of MiFID I was therefore to bring down the transaction costs for investors and secondly to facilitate the creation of a large secondary market which could eventually enhance liquidity by promoting and incentivising competition among trading venues.

With hindsight, our view is that MiFID I missed the objective of enhancing the level of liquidity in lit markets and reducing the cost of trading for investors. In fact, its effect on liquidity was the fragmentation across a plethora of trading venues, which made it more difficult for the buy-side to understand where to find liquidity.

Therefore, when during the long road that led to the birth of MiFID II the EU authorities launched a consultation process on the proposal to target dark pool trading and clamp down on access to dark liquidity, we (the buy-side) were very vocal on these topics. A group of buy-side asset manager representatives travelled to Brussels a number of times to provide evidence (through empirical statistics) to the regulators to show that restricting dark liquidity would not lead to any enhancement in the price formation process nor would it lead to a shift of liquidity from dark to lit venues.

Buy-side consensus
During those meetings, I remember how little conflicting views there were among the asset managers consulted. At the end of the day, our shared concern focused on ensuring that we did not lose the ability to invest money efficiently in the best interest of our clients.

Our opinion was very clear on this topic: capping dark pools might have led to suppressing rather than encouraging liquidity formation, with the risk of impacting negatively on long-term institutional investors, the very firms that are meant to be protected.

Our experience as large size traders was that trading on the primary exchanges could be significantly more expensive than in dark pools, especially in large size blocks, given the decreased market impact that dark pools offered compared with trading in lit markets. Dark liquidity was criticised for obscuring price discovery but yet we had not seen any evidence supported by robust statistical analysis showing a negative impact on price formation from dark trading. In fact, a higher level of trading in dark pools had been associated with improved lit market price quality.

As widely predicted by many professional investors, MiFID II remains challenged in its aim to bolster liquidity on traditional stock exchanges. At the end of the first quarter following introduction, MiFID II has led to:

  1. An almost instantaneous move from broker crossing networks (BCNs) to Systematic Internalisers (SI). Although both buy- and sell-side firms are still familiarising themselves with the SI regime, SIs are certainly among the biggest beneficiaries of the new MiFID II requirements. Liquidity previously exchanged in BCNs has de facto moved to SIs, where investors feel they have the advantage of tailoring their liquidity needs more appropriately than BCNs, given the greater transparency requirements of SIs vis-à-vis BCNs (”Trading Under MiFID II: Initial Impressions from ITG”, The Trade, January 2018);
  2. An increase in block trading. Fidessa’s Top of the Blocks report shows that the proportion of dark traded as Large In Scale blocks reached a record 28.7% on 12 January compared to 12% in January last year (“Moving towards the light”, The Trade Magazine, 22 March 2018). This is a trend that existed well before MiFID II and that was strengthened by the implementation of the regulation. Venues that offered Large-In-Scale (LIS) trading experienced significant growth and confirmed the scepticism of real money investors towards the capacity of lit exchanges to absorb large size trades while protecting them from predatory strategies. Platforms like Turquoise Plato, CBOE LIS and Liquidnet have all experienced a rise in volumes given the interest of buy-side players to keep trading in size and get their blocks done;
  3. Exchange operators such as CBOE Global Markets set new records on their periodic auctions book, recording double-digit growth in their average daily notional value traded. The new record was set on 12 March and was 20% higher than the previous record of €488 million seen on 6 February (“Cboe Periodic Auction sets periodic auction record as dark caps arrive”, The Trade, 13 March 2018). The ban of BCNs acted as a boost for periodic auctions, where investors find a cheap, transparent way of matching their orders.

It is clear that MiFID’s latest incarnation is no closer to forcing liquidity to lit markets and that this comes mainly from an oversight of the needs of real money investors. And these needs can all be linked to a very simple concept: institutional long-term investors keep the interests of their clients at the core of their investment decisions.

They represent the interests of a wide variety of clients, from institutional to high net worth individuals to pensioners. They trade large blocks of assets with the primary objective of doing it in the best market conditions and with the appropriate level of confidentiality in order to protect their investors and generate performance. The choice of trading venue is first and foremost driven by the opportunity to execute their clients’ orders with the best possible conditions.

A skewed playing field
That is why rules aimed at forcing to trade on a particular category of venues can be counterproductive to liquidity. Today the reality is that, even after MiFID II, if a large trade is spotted entering the market, that order is open to abuse by speculators. It is like a game of cards where the other players can see your hand.

In our view,  block trading venues will keep growing in popularity until institutional professional investors will be satisfied that they can trade on a level playing field where their trading data are protected and transparency rules are consistent with the liquidity level of the asset being traded.

Until that time, block trading will not only grow in volume but will be key to unlocking greater levels of liquidity directly from the buy-side to execution venues, although at this stage it is unlikely a wholesale shift from lit to dark trading venues.

Connectivity between communities holds the key to exploiting the scale, breadth and depth of the European trading market and is one of the most important drivers in establishing a sustainable future for block trading.

Buy-side professional investors are and remain in favour of regulation and indeed suggest a greater role for market supervisors to create and maintain a trading environment in which best practices are encouraged through greater transparency, comparability and choice between service providers.

However, a lot of work still has to be done in creating a level-playing field for safe standard trading protocols, which will determine the way trading data are transmitted and published and, consequently, the willingness of buy-side investors to confidently show their orders on lit markets.

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