EU Equity pre- and post-trade transparency regulation (LBF vol. 21) 2021/18.III.2.4.1:18.III.2.4.1 Dark liquidity on RMs and MTFs

EU Equity pre- and post-trade transparency regulation (LBF vol. 21) 2021/18.III.2.4.1

18.III.2.4.1 Dark liquidity on RMs and MTFs

Documentgegevens:

mr. J.E.C. Gulyás, datum 01-02-2021

Datum: 01-02-2021
Auteur: mr. J.E.C. Gulyás
JCDI: JCDI:ADS266995:1
Vakgebied(en): Financieel recht / Bank- en effectenrecht
Financieel recht / Europees financieel recht
Financiële dienstverlening / Financieel toezicht

Dark trading (also ‘dark liquidity’) refers to trading without pre-trade transparency. Dark trading can appear in several forms. One type of dark liquidity is trading without pre-trade transparency as facilitated by RMs and MTFs. The EU permitted RMs and MTFs to support dark trading through four waivers ever since MiFID I.1 The four waivers are still in place under MiFID II, albeit in a modified manner. The four waivers intend to serve market participant needs. The four waivers do so as follows:

1.: The large in scale-waiver is in place to help market participants trading large sized orders without substantial market impact.
2.: The reference price waiver initially (in drafting MiFID I) intended to mitigate reference prices to be manipulated, while under MiFID I and MiFID II the reference price waiver helps all types of market participants (also engaged in smaller sizes) to execute prices at the midpoint of the spread.2
3.: The order management waiver is in place to help market participants in efficiently managing their orders, in particular through permitting iceberg and stop orders.3
4.: The negotiated trade waiver is in place to help market participants in negotiating a better price than where the trade would be executed in the pre-trade transparent market. The waiver also aims to ensure that where negotiated prices do not reflect current market prices, these prices are not displayed in order to preserve an adequate price formation process.4

The four waivers are, in the final opinion of the EU, necessary to ensure liquidity is not impaired by pre-trade data publication. Market participants can use the waivers in order to protect or improve their trading positions. As explained in the previous sections and chapters, the market-led philosophy generally favoured all types of waivers, both protecting and improving trading positions. By contrast, the market-shaping model has traditionally wanted to protect (not: improve the trading position of) market participants by permitting pre-trade transparency exceptions. The consequence is that within the EU the large in scale-waiver and order management waiver have been relatively uncontroversial. By contrast, the reference price waiver (permitting midpoint execution for price improvements) and the negotiated trade waiver (permitting to negotiate a better deal) have resulted in clashes between the market-facilitating and market-shaping camps. Legal-historical analysis shows this is the case:

From MiFID I to MiFID II the market-shaping philosophy argued that the reference price and negotiated trade waiver had the potential to harm the price discovery process. The market-led philosophy by contrast emphasised the importance of the waivers for the trading positions of market participants, namely the reduction of trading costs.5 The final position of the EU reflects a shift towards a more market-shaping model. Whereas under MiFID I the reference price waiver and negotiated trade waiver could be used without caps, MiFID II introduces a so-called double volume cap.6 With the aim to protect price formation, the double volume cap restricts the use of the reference price waiver and one element of the negotiated trade waiver.7 The double volume cap does not apply to the large in scale and order management waiver.8 The MiFID II Review of ESMA shows willingness of ESMA to, at least, assess the whether the reference price and one type of negotiated trade waiver should be maintained.9 Whilst the final position of the EU is not yet available, the ESMA perspective echoes market-shaping elements in designing EU equity pre- and post-trade transparency regulation.

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Under the ISD there were also possibilities for dark trading on RMs (MTFs did not yet exist), such as hidden orders, but the EU approach for dark trading possibilities occurred only since MiFID I. For an examination, reference is made to chapters 3-4. For a similar point of view, reference is made to E. Banks, Dark Pools, Palgrave Macmillan, 2014.

The spread refers to the price difference between the buy and sell orders in a financial instrument. Execution at midpoint means that a market participant does not have to ‘cross the spread’. For example, where the buy price is EUR 9 and the offer price is EUR 10, the midpoint is EUR 9.50. Where a market participant wants to buy (sell) the price is EUR 9.50 instead of EUR 10 (EUR 9). In effect, the market participant obtains a price improvement.

An ‘iceberg order’ refers to an order that is partially visible (tip of the iceberg), whereas the rest remains in the dark. Once the tip is executed, a new ‘tip’ becomes pre-trade transparent, and so forth. Such a strategy is particularly useful for executing larger orders without substantial market impact (but might be insufficient in preventing other market participants in detecting the entire iceberg). A ‘stop order’ refers to an order that is executed once a predefined price is reached. Stop orders can be used to reduce losses (stop loss order) or to hedge risks when short-selling. In brief, a short-sale refers to the situation where a trader speculates on a drop, instead of increase, of the price of the financial instrument (L. Harris, Trading & Exchanges: Market Microstructure for Practitioners, Oxford University Press, 2003, p. 32). MiFID I covered a waiver specifically for orders such as iceberg and stop orders, that is – the order management waiver (art. 18(2) MiFID I Implementation Regulation). MiFID II retains the waiver, while providing additional detail. Reference is made to MiFIR Delegated Regulation 2017/587 and chapters 4-5.

See CEPS, MiFID 2.0: Casting New Light on Europe’s Capital Markets, 2011, p. 64. For an examination of the rationale of the negotiated trade waiver, reference is made to chapters 4-5.

For an examination of the drafting history of the MiFID II waivers, reference is made to chapters 4-5.

Art. 5 MiFIR.

Recital 17 and art. 5 MiFIR. The double volume cap mechanism limits the use of the reference price waiver and one element of the negotiated trade waiver through two thresholds. In brief, the percentage of trading in an equity instrument carried out on an individual RM or MTF is limited to 4% of the total volume of trading in that financial instrument. The waivers are also restricted in terms of trading an equity instrument taking place on all RMs and MTFs together to a percentage of 8% of the total volume of trading in that financial instrument (art. 5(1) MiFIR).

Art. 5 MiFIR.

ESMA, Consultation Paper: MiFID II/MiFIR Review Report, 4 February 2020(ESMA70-156-2188) and ESMA, MiFID II/MiFIR Review Report, 16 July 2020(ESMA70-156-2682). For an examination of the ESMA MiFID II Review of the double volume cap, reference is made to chapter 5(section VII).