The difficulties of meeting new European regulations, which come into force in less than a year, for best execution, dark trading caps and trading dual-listed shares have come into focus as the market awaits more guidance from the European Securities and Markets Authority.
In equities MiFID II, the regulations covering European financial markets from 2018, place double volume caps on trading in dark pools of 4% on any single venue and 8% market-wide in any 12-month rolling period, although large-in-scale block trades are excluded from these limits.
Christian Voigt, senior regulatory adviser at Fidessa, told Markets Media the double volume caps are hard-wired in the MiFID II legislation and will be very difficult to implement.
Christian Voigt, Fidessa
“There is limited definite publicly available data on dark trading today, so making predictions about the impact is extremely difficult as trading behaviour is likely to change once MiFID II starts,”said Voigt. “If the caps are too low trading could move to other countries outside the EU such as Switzerland, US or to Asia.”
Steve Grob, director of group strategy at Fidessa, added in a blog that dark trading venues are expected to launch this year to comply with MiFID II but will aim to trade in size on an infrequent basis, adding to the difficulty in measuring best execution.
“On top of this the market will require a new breed of smart router that can rest multiple orders in all the dark venues and then yank them out as fills come in,” said Grob. “This will need to be done in such a way that the senders are not accused of routing toxic flow to these venues, and done at speed so that the risk of getting overfilled is minimised (a big problem when you are dealing in real size).”
Grob continued that the latest Q&A from Esma last month raised the bar on best execution as firms are now expected to take “all sufficient steps” rather than just “reasonable” ones. In addition, he said firms will have to “verify on an ongoing basis that their execution arrangements work well throughout the different stages of the order execution process”.
He added: “Any useful notion of “best” is impossible without knowing the full trading objective (i.e. the exact combination of price, size and secrecy for an order).”
Voigt said some deadlines will have to met ahead of the MiFID II implementation date of 3 January 2018. For example, trading venues have to submit their waiver applications to their relevant national regulator by the beginning of next month for equities and no later than 1 June 2017 for bonds and derivatives. The deadline for investment firms to register as a systematic internalizer is 1 September 2018.
“Standardisatization of implementation is important when national regulators transcribe the directive into their laws,” Voigt added. “The market does not want implementations to differ hugely.”
Voigt continued that the new market structure will still be uncertain on day one of MiFID II implementation. “With MiFID, fragmentation only became apparent about two years after going live,” he added.
Law firm Ashurst said in a note that the MiFID II share trading obligation has been a known problem since it was negotiated as part of the MiFID II package. “However, it is only in the last year that firms have focused on how to incorporate the obligation into their business models; creating significant problems,” added Ashurst.
Ashurst highlighted that sending orders to non-MiFID II venues and counterparties in order to achieve best execution in deeper pools of liquidity may be prohibited. The law firm gave the example of Apple shares which are listed on Nasdaq in the US but can also be traded on Germany’s Deutsche Börse. The average daily traded value for Apple is €2.8m in Europe against €4.2bn in the US. EU investment firms that are not members of Nasdaq or other US venues will generally route client orders to US brokers who are members in order to achieve best execution.
“To put the problem in its starkest terms EU investment firms will not be able to carry out transactions, in dual listed securities, on foreign markets,” said Ashurst. “Instead, they could be forced to undertake this transaction on the EU trading venue, with best execution suffering.”
If Nasdaq is granted equivalence as a third country venue under MiFID II by Esma then the current arrangements could continue.
“However, this does not deal with the issue that significant amounts of volume are traded away from the lit order book – this kind of liquidity would not be available to EU investment firms,” said Ashurst. “Instead, the EU investment firm would have to execute (for example) on Xetra or a systematic internalizer (i.e. EU investment firm dealing on own account).”
Tim Cant, senior associate at Ashurst in London, told Markets Media that regulators may try to address the issue in Level 3 guidance on MiFID II, which should be out this month. “We understand that the AMF [the French regulator] and FCA [the UK regulator] want increased flexibility so that the best execution requirements are not overridden,” Cant said.
Voigt added: “Dual listings is a perfect example of the unintended consequences of regulation. I’m hopeful and optimistic that the issue will be address in the Level 3 Q&A as even regulators want to see trading done in liquid markets.”
Ashurst also highlighted that EU financial centres have historically acted as booking centres for group affiliates located in Asia/US but these types of arrangements may not continue to be possible in relation to shares. “London, Paris and Frankfurt will have to undergo significant behind-the-scenes restructuring in relation to booking models” said the law firm.