The Dark Pools of MiFID II

EPA/ARMANDO BABANI

Two puttis on top of the entrance of the stock exchange in Frankfurt Main, Germany. 

The Dark Pools of MiFID II


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The success of newly introduced regulation can be judged by the extent to which the effects of its implementation do justice to the regulation’s intent. The principal intention of MiFID II is to increase transparency in trading by moving much of it out of the dark and onto regulated marketplaces. Whether or not the regulation succeeds in this respect remains very much open to question.

One way that MiFID II seeks to move trading into the light is by applying significant restrictions on ‘dark pools’ of liquidity. The new regulation also seeks to clarify the Systematic Internaliser (SI) concept, which was introduced in the initial MiFID regulation of 2007 but not widely adopted. Restricting dark pools and expanding the SI regime are two sides of the same coin.

What are these ominous sounding ‘dark pools’? Judging by how they are characterized in books such as Michael Lewis’ ‘Flash Boys: A Wall Street Revolt’ and Scott Patterson’s ‘Dark Pools: The Rise of A.I. Trading Machines and the Looming Threat to Wall Street’, one would be forgiven for thinking they offer no value to the marketplace. This is far from the truth. Dark Pools were originally introduced in the United States to serve an uncontroversial purpose – to facilitate block trading by institutional investors, so that significantly large orders wouldn’t impact the markets by shifting prices against their favour.

However, they quickly grew to make up a material percentage of overall traded volume. While the initial intent of dark pools was legitimate, the effect of increasing volumes of trade shifting to these pools – whose intricate components even professional investors struggle to understand – has been to steadily reduce market transparency and efficiency.

What are these intricate (and by their nature hidden) components? Broadly, (a) the manner in which orders are handled within such pools, (b) the identity of one’s counter-party to a trade, and (c) the varied incentives offered to participants in such pools. All such factors contribute to dark pools being vulnerable to potentially predatory trading practices.

And what is the role of the Systematic Internaliser regime? SIs are investment firms that execute client orders against their own risk book, outside a regulated market. MiFID II expands the scope of the original regulation’s definition of Sis, such that traders will mutually benefit from having more information about their respective counter-parties, enabling them to make more informed decisions.

The intent is to provide a more limited vehicle for bilateral trading, but in the course of the lead up to the date of implementation on 3rd January 2018 it has become clear that some market participants have been considering ways in which they might be able to operate within the letter of the law while avoiding its intent. Indeed, there was sufficient concern at ESMA that its intent would be circumvented that it issued a press release on April 5, 2017 clarifying the activities of Systematic Internalisers in order to prevent the establishment of SI networks which would have effectively reproduced dark pool behaviour.

Financial tools are only as good or bad as the people and institutions who wield them. MiFID II is an example of an evolutionary form of regulation (having quite literally evolved from MiFID I). Where previous legislation (the likes of Dodd-Frank, following the crash of 2008) – for understandable reasons – has tended to be reactive and therefore often arbitrary, the new legislation embodies an attempt by ESMA to more closely align the European regulatory framework with its original intent, ultimately this represents a more positive and less punitive approach to financial regulation. Quite simply, it actively encourages firms to know more about one another, and this will help to foster long-term relationship building.

We can acknowledge the legitimate need for transacting large orders with minimal impact without ignoring valid concerns about how this is achieved. In so doing, we posit that the term ‘zero sum game’ does not adequately describe what happens in the markets. In trading financial products, one person’s trash can be another person’s gold.

Europe’s mammoth new regulation contains 1.5m paragraphs, running over 70,000 pages. Reading between the lines, however, what’s most notable is that its underlying intentions should help foster healthier long-term relationships amongst trading partners. The more I know about the person with whom I’m exchanging goods, the better I know whether I’ve benefited from interacting with them. If I consistently suffer from these transactions on a short-term basis, I won’t be doing business with them in the future. Therefore my decisions become better informed.

It’s that simple. In attempting to drive more trading back onto the lit, regulated markets – or at least into liquidity pools which provide participants with greater transparency on who they are interacting with – the areas in which predatory traders can operate are minimized. The more we see and know, the better we trade.

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