Magazine Issues » December-January 2013

EXCHANGES AND MTFs: Doing it in the dark

LanternDark pools are designed to benefit buy-side traders, but these advantages could be under threat as trading volumes flatten worldwide. Nicholas Pratt talks to some of the leading dark venues in Europe to see how they are meeting this challenge.

The original objective of dark pools – trading venues whose liquidity is executed anonymously and away from central exchanges – was to help buy-side firms to trade large orders without incurring any market impact.

But there is a fundamental problem in that buy-side firms are finding it harder to have their orders filled, says Steve Grob, group director of strategy at Fidessa, a developer of order management systems.

“There has been a flattening of total volumes but the number of dark venues has remained the same, or even increased. Consequently, buy-side traders are having to place smaller orders over a larger number of venues and this in turn increases the risk of leakage or other adverse market impact.”

The dark multilateral trading facilities (MTFs) resulted from the revolution in Europe’s equity markets brought about by the Markets in Financial Instruments Directive (Mifid) legislation, which was designed to make trading more harmonised, more transparent and more competitive for buy-side firms and their end investors.

But it could be argued that the burden of extra complexity and fragmented clearing has outweighed the benefits of reduced transaction costs, especially in light of flattened trading volumes.
But, says Grob, if you accept that the current market conditions are here to stay for a while, then there is an opportunity to build a more intelligent trading landscape suitable for buy-side traders, starting with buy-side to buy-side crossing networks, then brokers and their dark pools and finally hitting the “lit” markets. “Above all, buy-side traders want something neutral, something safe and something reliable.”

BATS Chi-X Europe, the result of BATS Trading’s acquistion of Chi X Europe in February 2011, has the largest volume of all the MTFs, both in the lit and dark markets. Both dark MTFs operate on the same platform but the focus for 2013 will be on differentiating the two trading books both in terms of price and order types, says Mark Hemsley, chief executive at BATS Chi-X Europe.

Central to these plans has been the introduction of an electronic order type that sweeps both dark MTFs in search of best execution.

The fall in volumes across all markets has put pressure on some dark MTFs, says Hemsley. “We have not seen an awful lot of change in the rankings of MTF dark pools.

“For us, the vast majority of our flow is on the lit market and the incremental overheads for running the dark pool are very low. But for those operating just a dark market, this could potentially be an issue.”

He says the 5% of flow that goes through the dark MTFs may start to concentrate on the larger pools. “If this led to some dark MTFs exiting the market, this would probably be a good thing for buy-side trading firms as they would spend less time interacting with pools that haven’t got much liquidity.”

The EU is set to introduce Mifid II in the next two years. One likely outcome is the removal of broker crossing networks – dark pools that are unregulated under Mifid and discretionary in terms of participants.

It has been said that as to whether the fact that the removal of broker crossing networks is a sign that the commission is not listening to the buy-side, Hemsley says that this is probably because the main ones lobbying for the maintenance of broker crossing networks are the banks (albeit on behalf of the buy-side). And banks’ lobbying efforts are sometimes treated with scepticism by regulators.

“The buy-side would have more impact if they were heard directly rather than via the banks and brokers so I would emphasise that they should get involved and get organised.”

Liquidnet is the most buy-side focused of the leading dark MTFs and its primary focus is on enabling its buy-side membership to execute large orders anonymously. Liquidnet’s average execution size is €800,000 compared with between €5,000 and €10,000 in the lit market.

“We operate on the institutional side where firms are more interested in size rather than speed, so our priority is to provide liquidity and reduce market impact, thereby reducing overall transaction cost,” says Per Lovén, head of Emea corporate strategy at Liquidnet.

Although overall trading volumes are slightly down, dark trading has increased its share of overall volumes relative to lit trading. Lovén says this growth is because of greater recognition of best execution among institutional buy-side firms and an appetite to trade in large block sizes.

“In a low volume environment, liquidity is more valuable than ever. If we can offer our members more liquidity in names that don’t trade in high volumes, that will be increasingly attractive.”

In terms of changes from Mifid II, Loven believes it is unlikely that activity conducted through broker crossing networks will not disappear in the next two years. More important for buy-side firms is the potential removal of waivers over pre-trade transparency used by dark MTFs.

“If the large in size and the reference price pre-trade transparency waivers are removed, this will directly impact the performance of fund managers.

“We have long been advising our buy-side members to be vocal. The policy makers in Brussels want to hear from the end investors, since their interests are less directly profit driven. They are being listened to but there is more that can be done.”

The UBS MTF has been the biggest mover in the rankings of trading volumes for dark MTFs over the past 18 months. It now ranks alongside the two dark MTFs of BATS Chi-X Europe in terms of trading volume with a 20% share by value of the Emea All Countries Dark Order Book as recorded by Thomson Reuters Equity Market Share Reporter.

Robert Barnes, the chief executive of UBS MTF, puts much of this success down to the provision of interoperable clearing, a full stock universe of 16 countries, the ability to place orders at bid, mid and offer positions, and meeting customers’ requests for new features, such as the admittance of depositary receipts.

As a segregated venue, the MTF is used by its broker members executing on behalf of their buy-side clients rather than directly by the buy-side.

“We do not mandate a minimum size for orders. We give our customers the choice to set minimum acceptable quantities to differentiate their offers to their buy-side clients. The more sophisticated brokers are able to use tools dynamically to set and amend minimum order size relative to how they interact with liquidity in our non-discretionary matching venue in order to get best execution for their clients.”

Barnes also believes that the challenge of sustaining high volumes in a low trading environment will lead to a concentration of liquidity on the top handful of dark MTFs.

“In a resource-constrained environment, people have to prioritise so where there is choice, they are connecting to the top meaningful venues in both the lit and dark markets.”

Barnes also thinks that the dark MTFs will continue to grow under Mifid II, provided that the aforementioned waivers are retained.

“From the UBS MTF point of view, we are very grateful for the much improved transparency framework and having post-trade transparency acting as the pre-trade transparency for the next price is a great example of how lit and dark venues complement each other.”

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