European politicians may want greater transparency but by pushing all equity market order flow onto traditional primary “lit” exchanges, they may well risk harming the pension funds and retail investors they want to protect due to poor trade execution.
This is what asset managers tell TABB Group in new research published on the eve of continued MiFID II trialogue meetings as dark trading volume exceeds 10 per cent.
This new high was achieved as nearly 25 per cent of the asset managers now trade over 30 per cent of their order flow off-exchange – only six per cent refrain from accessing alternative liquidity sources, declining from 15 per cent in 2011 – but with the ability for long-only investors to execute institutional order flow still heavily constrained, 85 per cent of the asset managers interviewed are using dark pools to limit information leakage.
“Alternative liquidity pools – dark pools – matter and they’re attracting trading volume,” says TABB senior analyst Rebecca Healey, author of “Dark Matters,” based on interviews with 94 institutional asset managers trading European equities with EUR14.2trn in assets under management (AuM) worldwide.
The decline of traditional methods to execute institutional large order flow via block trading or using risk prices, Healey explains, combined with a decline in European equity volumes, forces investors to seek alternative sources of liquidity. But due to increased volumes away from the exchanges, European politicians say there is a need for greater supervision of dark venues to limit trading in non-transparent markets and return volumes to transparent exchanges, enabling investors to detect a credible price signal. There is no guarantee this will happen, she says, as greater regulation may in fact increase the requirement for further alternative trading methods.
Over two-thirds of the asset managers interviewed worry that the proposed regulation of capping dark activity will negatively impact how they can execute order flow, says Healey. “Their concerns could lead to greater consequences, such as structural changes in investment strategies, such as whether to invest in small and mid-cap stocks, as well as implications for execution, adding complexity and higher trading costs to pension fund performance.”
Automated access to alternative liquidity pools is changing structure. As Healey points out, dark multilateral-trading facility (MTF) trading increased 31 per cent in the last year versus 11 per cent growth for broker crossing systems (BCS), as trading opportunities reached a plateau due to a limited ability to cross client order flow internally.
“BCSs remain valued by institutional investors for their ability to control which participants have the ability to trade, thereby improving the quality of liquidity the pension fund manager interacts with. However, 52 per cent of the participants believe more could be done by brokers to increase transparency within the pools,” says Healey.
To achieve this transparency, TABB proposes four recommendations be implemented prior to further regulation of alternative liquidity pools that could inadvertently damage liquidity and the ability to execute institutional order flow in the process:
• Mandated Consolidated Tape with harmonized reporting standards
• Calibration of transparency requirements for large-, medium- and small-cap stocks
• Retention of the Equity OTF but with limited and simplified categories and order types
• Ensured flexibility within the rules by basing these on technical guidelines via a pilot scheme, delegated to ESMA
Europe is not alone in redefining effective market structure, Healey says. “But regulators here face a tough task in setting market structure rules and responding to unintended consequences, which often involves political pressures. Focusing on prevention, not the cure, through improved standardization of data will increase chances of robust monitoring and markets supervision. This will benefit everyone – from pensioners, to fledgling small or mid-cap stocks across Europe.”