Part 4 – Dark pool trading caps

Why are dark pool trading caps anti-competitive?

Conclusion

“Name one EU regulation or law you would change?”This question is often posed to Brexiteers, usually by those who believe Eurosceptics lack detailed arguments or, worse still, didn’t know precisely what they were voting for. Though this may be true in some cases, EU-friendly commentators are also, at times, guilty of a myopia of their own – assuming that the current regulatory status quo automatically equates to ‘best practice.’ In reality, the European Union has been responsible for a raft of regulations which have increased costs to businesses and consumers. While much is made of the business compliance cost of certain regulations, less attention is generally paid to the anti-competitive harm they cause. Increasing costs for certain firms, and forcing some (especially smaller, firms) to exit the market can have the effect of raising prices for consumers and diminishing capacity. Anti-competitive regulations make it difficult for new competitors to enter the market, thereby entrenching existing companies and leading to the formation of oligopolies.This blog series examines a number of regulations, with anti-competitive effects, to illustrate how they work and the harm they cause. We saw last week how MiFiD II’s onerous data collection requirements have proven much harder for smaller traders to absorb than their larger competitors.This Directive also limits the amount of equity that can be traded outside of regulated exchanges through dark pool trading caps – something that is already having unintended consequences on the financial sector.Dark pools are private venues run by banks, exchanges or independent operators where transactions are cheaper and – crucially – anonymous. In contrast to exchanges, where deal information is displayed before a trade is executed, dark pool prices are disclosed only after a trade has been completed.MiFID II limits dark pool trades to just 4% of total traded volume in a stock on any single dark pool over a rolling 12-month period, and a maximum of 8% of total traded volume in a stock across all dark pools. A breach of either means trading in that stock is suspended for the next six months – either from the individual dark pool that breached the 4% cap, or from all dark pools when the 8% cap is reached. What was the goal of the regulation? Regulators hoped to move transactions back onto public – “lit” – exchanges, to re-establish them as the main trading venues for Equities and to improve overall valuation and transaction transparency.Was this regulation ever necessary? Dark pools were originally created to allow large block trades to be completed away from public scrutiny, so as not to affect the market price before the deal was done. Earlier this year, it was estimated that just over 45% of the daily volume of equity trading happened away from exchanges in Europe, either on dark pools, periodic auctions, OTC markets or Systematic Internalisers (SI) run by investment firms and high frequency trading companies. These off-market vehicles have become popular among fund managers who are reluctant to buy or sell large blocks of shares via a public exchange, alerting other investors of their intentions and pushing the price against them.However, there is a major concern that the prices on public stock exchanges no longer reflect true investor demand, due to the popularity of off-market transactions. Even the operators of the various off-market vehicles should be concerned by this as they also rely on “lit” exchange transaction data to formulate their off-market prices. Regulators are also worried that the off-exchange activity is more difficult to monitor. In the US, dark pool operators have received large fines for misleading investors and market manipulation. In 2016, Barclays, Credit Suisse and Deutsche Bank were all fined by regulators for misleading clients in dark pool trading.Firstly, instead of moving trading back onto lit markets, caps on dark pool trading have merely directed traffic to other off-exchange transaction vehicles not limited by MiFID II.So far, most of the volume previously traded in dark pools has moved to trading in Systematic Internalisers – which rose by 6% in Q1. These are investment firms which can execute client orders in-house. On the NASDAQ Nordic markets the SI market share has increased from low single digit figures pre-MiFID II – to well above 25% of transactions.All of this begs the question – if off-market trading really causes information asymmetry between investors, then why have EU regulators chosen to impose a volume cap on dark pool trading rather than banning off-exchange transactions altogether?Secondly, the caps hurt the most traded markets and equities unnecessarily. Although the equities that have been suspended so far account for only 2.5% of all equities listed by the EU financial regulator ESMA in their transparency calculations – they make up 35% of the most liquid listed equities traded on EU markets. The caps have had an immediate and pervasive effect since their implementation in March this year. As of June, 932 companies had breached the limits, including the biggest and most liquid EU stocks in both the major and mid-market indices. 85 of the stocks in the FTSE 100 have now reached the 8% cap, along with 80% of stocks in the three Nordic indices.This is detrimental to the market as it restricts one of the most effective methods of trading for large investors. The levels ESMA used for the caps also seem arbitrary. The Financial Conduct Authority believes that off-exchange trading only begins to negatively affect market quality at between 11% and 17% of market turnover – a much higher level than MiFID II’s dark pool caps of 4% and 8%. It is ridiculous to impose the same volume limits on all equities regardless of the company size, volatility, market structure, taxation system or even the amount of listed capital freely available. A national taxation system that encourages companies to pay out dividends rather than accrue earnings will generally have lower trading volumes and so fewer suspended stocks. As will companies where founding families still own large amounts of the listed capital.Finally, EU regulators’ ability to calculate the trading volumes used to impose the caps is less than perfect. Despite having incomplete data at the time the caps were implemented, ESMA still decided to push on regardless, with predictable consequences. In April, ESMA reported corrections for 34 stocks it mistakenly suspended from dark pool trading the previous month.Off-market transactions developed for a reason. Since the rule change, trading has continued on alternative venues, because large funds need to be able to trade in large volumes without disturbing the market. Given that the world’s 20 largest fund managers now all have over $1tr assets under management (AUM), and even “large” funds have over $100bn AUM, there needs to be an efficient way for these funds to change their investment portfolios without disturbing the market for everyone else.Although the dark pool caps have only been in place for a few months, they will undoubtedly have consequences on how – and, more importantly, where – large funds place their equity orders. Any effort to reduce off-exchange trading and increase transparency in the equity markets must be balanced against the adverse effect on market volatility and investment valuations caused by large volume transactions.