By Josephine Mason
LONDON (Reuters) – Tough rules aimed at boosting European equity trading volumes on regulated public exchanges appear to have failed a crucial test, data shows, undermining regulators’ efforts to raise transparency almost one year after the reforms were introduced.
In March, the European Union’s Markets in Financial Instruments Directive, or MiFID II, introduced temporary caps – on trading volumes in dark pools – non-transparent venues where trades do not contribute to price formation.
They applied to more than 600 stocks including the majority of European and FTSE 100 index components.
Regulators had hoped the curbs would be enough of a slap on the wrist to deter investors for good and trading would remain in so-called ‘lit exchanges’ — where prices and trades are clearly visible – even after the limits expired in September.
But data compiled by brokerage Rosenblatt Securities and seen by Reuters shows the market has returned to its old habits, with trading volume shifting almost immediately back to dark pools.
In February, the first full month before the caps took effect, dark multilateral trading facilities (MTFs)- alternative dealing systems born from the first iteration of MiFID – accounted for 4.51 percent of consolidated turnover across Europe.
In the month before the first set of caps expired, dark pools traded just 2.16 percent of volume in banned stocks.
But in the month after the caps were lifted, dark pool market share for capped stocks had more than doubled to 5.13 percent, while lit venues for capped stocks lost 349 basis points to 33.04 percent and periodic auctions fell by almost half to 1.17 percent on the same basis.
Trading at over-the-counter (OTC) and bank-run trading venues called systematic internalisers (SI) grew a combined 256 basis points on the same basis, but inconsistent trade-reporting practices make this data unreliable, the Rosenblatt report said.
The European Securities and Markets Authority (ESMA), which designed and implemented the reforms, declined to comment on the report.
The findings undermine Brussels’ ambitious plan to reduce trading “in the dark” and boost transparency, revealing for the first time that investors are adjusting to the reforms and still flocking to private venues.
“Our analysis of trading data before and after (the expiry) suggests that the caps have not dampened appetites for non-displayed venues or achieved European policymakers’ goal of growing lit-exchange market share,” said the report.
Many market participants argue that the less transparent venues offer a helpful service for large investors who want to avoid prices moving against them when executing big trades.
For this reason, large blocks of shares are exempt from the caps.
Trading volumes also show a jump in dark pool activity after the caps were lifted. Last month’s dramatic sell-off boosted turnover in equities across the region, but dark pools’ volumes saw an outsized bounce.
The share of trading on lit exchanges hit 931.6 billion euro (825.04 billion pounds) in October, up 36 percent from September, according to data from Refinitiv’s Market Share Reporter.
Dark pool turnover soared by 59 percent to 62.1 billion euro from a month earlier, its highest since February.
Graphic — Dark vs Light: Investors return to dark pools — https://tmsnrt.rs/2PSQ26m
The data also has exposed the flaws in the design of the legislation, which lawyers and experts say is too blunt an instrument to deal with a complex, nuanced market structure.
Most criticism is aimed at so-called double volume caps: over a rolling 12-month period, just 4 percent of total trading in an individual stock can take place in any dark pool, whilst trading in any share across dark pools is limited to 8 percent of total volume.
Once those quotas are exceeded, trading in that security in dark pools is banned for six months.
Investors switching in and out of the dark pools as those limits are imposed and lifted creates market “whiplash”, said Nathaniel Lalone, partner at Katten Muchin Rosenman UK LLP.
“The design of the caps seems to be creating a see-saw effect that will likely move many stocks in and out of dark MTF every 10-12 months,” said the Rosenblatt report by vice presidents Anish Puaar and Alex Kemmsies and managing director Justin Schack.
They said the data highlights how the market prefers the lower execution fees in dark pools compared with exchanges. Regulatory scrutiny of periodic auctions and SIs may be deterring some traders from using them, they said.
If see-saw trading volumes are sustained, lawyers and experts say regulators may have to adjust the model to disincentivise investors from returning to the dark pools.
“If it becomes clear the system as it was intended isn’t working, then they (the regulators) have to stop it,” said Lalone.
“The aim might be right, but the lived reality might not be.”
The European Commission could extend the period of the timeout for banned stocks to deter investors for longer or adopt rules that are more in line with Canada and Australia where legislators opted for rules that required a big price or size improvement in dark markets, experts said.
“Absent the push to have trading on non-dark mechanisms, people fall back into old habits,” said Lalone.
The Commission is due to submit a report to the European Parliament on the impact of the volume cap mechanism, among other aspects of the rules, by March 3 2019, according to MiFID legislation.
“Brexit preparations may cause this review to be shunted down the list of European regulators’ priorities. Nevertheless, regulators will have an opportunity to tweak the rules,” the Rosenblatt report said.
Earlier this month, ESMA said it would look at the growth in periodic auctions – closed intra-day auctions on exchanges – and asked for market feedback by Jan. 11.
Graphic — European equities turnover in dark pools in October — https://tmsnrt.rs/2PSQ26m
Graphic — European lit exchange turnover in October — https://tmsnrt.rs/2PSETm9
(Reporting by Josephine Mason; additional reporting by Helen Reid; Editing by Gareth Jones)