Out of the shadows
Rising dark pool volumes in Europe suggesting growing comfort among buy-side firms, so are institutional investors happy with the current regulatory environment for off-exchange trading?
Not entirely. There is currently a distinct lack of transparency for over-the-counter (OTC) trades, an issue recognised by regulators too.
Currently, all OTC transactions are lumped together in post-trade data, including those which aren't considered as having a beneficial change of ownership and trades executed in broker crossing networks (BCNs).
This lack of granularity means post-trade consolidated tapes created by vendors thus far exclude potentially relevant off-exchange data, leaving the buy-side struggling to eliminate trades that are essentially meaningless for benchmarking execution performance.
With OTC trading totalling €513 billion in February, according to Thomson Reuters – compared to €840 billion for order book and auction trades – this represents a significant amount of inadequately reported market activity.
So what are regulators planning to do?
In its MiFID consultation, the European Commission (EC) proposed greater granularity of over-the-counter (OTC) transactions. As well as better visibility on the types of transactions done bilaterally – such as risk trades or give-up trades – the proposals would also increase transparency requirements for BCNs.
Under the consultation, BCNs would become a subset of a new organised trading facility category. As part of this regime, BCN operators would have to identify executed transactions under post-trade transparency provisions in MiFID, and make public aggregated information at the end of each day about the number, value and volume of all transactions executed using the system.
Surely this was an issue that should have recognised before MiFID was enacted?
Yes, but it was largely thought that the industry would come together to improve the specifics of OTC data.
A working group was established prior to the EC consultation to identify the types of flags that would be required for OTC data. The group has devised seven flags comprising: benchmark trades; agency crosses; give-up/give-in trades; dark trades; technical trades; ex/cum dividend trades; and negotiated trades.
While the EC didn't mention the working group specifically, it is widely assumed that its final legislative proposals, expected in mid-May, will give the European Securities Markets Authority (ESMA), the new pan-European securities regulator, the power to issue standards in this area.
Greater transparency is all well and good, but isn't there a danger of going too far and increasing trading costs for institutions?
Yes. The EC wants to apply pre-trade transparency requirements to stubs, or residual portions of a non-displayed trade executed under the large-in-scale (LIS) pre-trade transparency waiver, which is likely to increase buy-side trading costs.
Under the proposals, if a buy-side trader executes a trade on a block trading venue, he/she would now be required to find an alternative lit venue for a stub if that venue has no provisions for dealing with them. As well as increased execution fees, this also risks greater market impact.
If the EC's goal is to enhance price formation, the benefits of this particular measure would be negligible. In technical advice sent to the EC prior to the consultation phase, ESMA's predecessor, the Committee of European Securities Regulators (CESR), noted that just 1.1% of all European trading was executed using the LIS waiver in Q1 2010.
The EC also wants to tighten up the trade reporting regime. Will this have a direct effect on trading costs?
Yes, and quite a substantially negative one at that. The EC has proposed shortening the delay applied to reporting of large trades to no later than the end of the trading day, which will raise costs for trades that require capital commitment from the broker.
Currently, trades can be delayed for between 60 minutes and three days, depending on the average daily turnover of stock and size of trade. The delays give brokers time to unwind risk trades before reporting them to the wider market.
This means traders could find themselves rushing to complete orders before trades are exposed to the wider market, thereby increasing implicit costs. Furthermore, the increased risk associated shortening the delay is likely to priced into the capital commitment service offered by the sell-side.
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