One of the most controversial sections of MiFID II concerns equity market transparency, the so-called Double Volume Caps (DVC) on dark pool trading. The Double Volume Caps aim to limit trading in non-displayed liquidity (i.e. dark pools) by introducing a cap on the use of two transparency waivers, the Negotiated Trade Waiver (NTW) and the Reference Price Waiver (RPW) as follows:
- A venue cap of 4% and a global cap of 8% on usage of the Negotiated Trade Waiver (NTW) and the
- Reference Price Waiver (RPW).
- Only NTW trades, in stocks categorised as “Liquid”, will be subject to the cap calculation.
- The DVC is not the only limitation that affects dark pool trading. Others include:
- The bid/offer option in the RPW as reference price will be removed (only mid-price will be allowed).
- The NTW can no longer be used for “automated trading”.
However, trades exceeding the Large In Scale (LIS) threshold can be reported under the LIS waiver to avoid inclusion in the cap calculation.
This proposition has been heavily criticised for going too far. The ability to trade non-displayed liquidity is important when aiming to reduce implicit execution costs. Furthermore, there is still no clarity on how the DVC will work in practice. The following example focuses on the Negotiated Trade Waiver, a model of trade reporting that is used extensively in Sweden, Finland, Denmark, the UK and some continental exchanges.
What Options Do Investment Firms Have?
Faced with the reality of Double Volume Caps, market participants must choose a path forward. While the effects of the DVC are not yet known, it is clear that investment firms now have several theoretical and practical options. These include:
- To trade in the lit book. Instead of crossing two agency orders, each order is sent to the lit book for execution at the bid (the sell-order) and the offer (for the buy-order). While this is the regulators’ preferred choice, market participants will probably choose this as a last resort, due to the expected major market impact. Buyer and seller share the spread cost, instead of trading within the spread with no associated spread cost.
- To wait until order volume is aggregated and the LIS threshold is reached. In this case, the LIS waiver would (theoretically) make it possible to trade report, even if the instrument is capped. However, the Technical Advice [ESMA/2014/1569] states that "…ESMA should explicitly specify that aggregation of client orders should not be used for the purpose of artificially creating a total order size that results in an order size which falls above that large in scale (LIS) thresholds and therefore can be executed without full transparency”.
- To trade OTC. One of the goals of MIFID II is to move trading from the OTC space to regulated venues.
- OTC trading will still be allowed, but not on a regular and frequent basis. The regulators have been very clear in their communication that the OTC alternative must not be used to circumvent the DVC.
- To hope for a new, yet unknown innovation, such as BATS Chi-X elegant model for periodic auctions, to reduce the risk that the caps are hit. The industry will certainly expect new innovation, but the regulators will be watching out for any attempt to circumvent the caps.
- To use a Systematic Internaliser. This might be an effective way to mitigate the caps — in specific cases.
The Client Facilitation Case
Let’s examine the case of a Nordic investment firm that has conducted a client facilitation trade with volume
1) Does The Trade Contribute To Price Discovery?
The Trading Obligation (Article 23(3) of MiFIR) states that there is an exemption from reporting a trade on a regulated venue if the trade does not contribute to price discovery [EU 600/2014]. If eligible for this exemption, the trade is considered an “administrative transaction” and is not interesting in the context of the DVC. Nearly all trade reports will pass this test with a “YES”. However, from a regulator’s perspective, further analysis is required to ensure that the firm is not seeking to exploit regulatory loopholes.
2) Is The Trade Report Done In A Liquid Stock?
As already discussed, the new definition of Liquid stocks (“Liquid markets”) will most likely result in more stocks deemed as “Liquid”. One example is the Swedish market, where currently 75 stocks are deemed liquid. With the new definition, more than 90 stocks (> 94% of the turnover) will fall into that category. The rules for the DVCs state that only Liquid stocks should be hit by the cap calculation. In practice, this rule will be of little value since only around 5% of the turnover will be exempt from the DVC.
3) Does The Trade Reach The Large In Scale Threshold?
The quantity required to reach the LIS threshold is substantial. The “LIS-exit” in the decision tree above will not suffice to avoid the DVC challenge.
4) Is The Instrument Subject To A Suspension Of The Ntw And Rpw Due To The Double Volume Cap?
If the DVC threshold of 4% is reached, the usage of the NTW and RPW is suspended for six months on that venue. Until the EU-wide cap of 8% is reached, dark pool trading and negotiated trade reporting, using the RPW and NTW, will move to a venue where the cap is not (yet) reached. When/if the 8%-cap is reached, neither the NTW nor the RPW is allowed in that particular instrument. In order to have the metric ready for January 3rd 2017, the venues have been requested to start measuring and reporting to their competent authorities as of January 2016. There will be challenges and problems due to lack of trade type and waiver categorisation standards, but usable data will likely be available by January 2017.
5) Is The OTC Alternative Available?
One theoretical option is to do the trade report OTC. This is used on a number of European markets today.
However, the new MiFID II regulation limits the options to trade OTC (see above under “Trading obligation”).
Furthermore, the regulators are on the lookout for any attempt to circumvent the regulation:
- “Such an exclusion from that trading obligation should not be used to circumvent the restrictions introduced on the use of the reference price waiver and the negotiated price waiver or to operate a broker crossing network or other crossing system”. MIFIR 2014/65
Using the OTC option in this case will cause trading to move from regulated venues (using the NTW) to OTC. This is clearly not what the regulators intended.
Given the market models we have today, this investment firm must use its own Systematic Internaliser to maintain its client facilitation business.
Even if the firm does not reach the thresholds required for automatic classification as a Systematic Internaliser, it is very risky to draw the conclusion that there is no need to become one. That conclusion is based on the assumption that a new market structure will emerge, and that it will eliminate the risk of the NTW and PRW reaching the caps. However, even if new market models such as the BATS periodic auction will reduce the risk of ALL benchmark stocks hitting the caps, many instruments will still suffer from suspended usage of the caps. An investment firm cannot limit clients to “trade any stock with us, as long it is not subject to the DVC.”
Furthermore, there is a significant risk that the liquidity in the order books will suffer from the new regulation:
- Tick-size changes (a reduction of tick size will reduce value of time priority).
- Market maker obligations and compliance impacts that will restrain liquidity providers to continue
- provide liquidity.
- Order flow will move to LIS dark pools due to the Double Volume Caps.
It is likely that new Systematic Internalisers will appear to offer an alternative to the order books on the trading venues. Considering the risk/chance that Systematic Internalisers will be exempt from tick size rules, one possible scenario resembles the effects of the “tick size war” that led to the implementation of FESE-2 and FESE-4, i.e. e the order flow is “forced” (due to Best Execution requirements) to the venue with the tightest spreads. This may also result in a two-tier market since it is possible to treat multiple client categories within a Systematic Internaliser.
So, while there is no regulatory requirement for firms that don’t reach the thresholds to become Systematic Internalisers, there is a solid case for firms that wish to gain a competitive advantage to do so.
For a more comprehensive analysis of this subject, please refer to Orc’s whitepaper “Can a Systematic Internaliser regime mitigate the negative effects of the Double Volume Caps?”
By Christer Wennerberg, Head of Market Structure Services, Orc Group