Nearly two years after the implementation of MiFID II, the equity market landscape is now taking shape. What was initially a race to be compliant has rapidly morphed to a battle of who can evolve their business models to take advantage of the new market structure and behaviour.
The regulators focus on improving market transparency has not had the desired effect. Despite banning broker crossing networks, implementing stringent regulation of internal matching, and the dreaded dark pool caps, liquidity remains highly fragmented. ESMA now lists over 210 systematic internalisers, 235 multi-lateral trading facilities, and 136 regulated markets. While not all equity venues, this is hardly a recipe for greater transparency and better execution outcomes.
One standout development is the surge in volume traded during periodic auctions since the implementation of MiFID II, which has rapidly grown from less than 0.5% to around 2.4% of the order book market. Many investors appreciate the execution quality that periodic auctions can bring, but there are also concerns regarding the price determination process and pre-trade transparency. As volumes traded at auction increase, regulators will need to decide whether greater oversight is needed, but in the meantime, periodic auctions have become an important source of liquidity.
A recent academic study (Quasi-Dark Trading: The Effects of Banning Dark Pools in a World of Many Alternatives) provides a contrarian view of the impact of double volume caps on dark pools. The authors demonstrate that when volume levels are breached, liquidity shifts to other off-exchange execution venues, and does not revert to lit markets as intended.
One of the results of this is the rise of ‘quasi-dark trading’ via systematic internalisers. There has been a significant shift in liquidity to this form of execution, with TABB Group estimating that SI’s account for as much as 13% of addressable equity trading activity across Europe. Prior to MiFID II this was less than 1%. Firms who initially stepped back from declaring themselves as a systematic internalisers due to transparency, reporting and cost concerns, are now reviewing their decision. Given tight margins and subdued volumes, are non-SI’s losing out by trading away? Should they first be looking to match orders internally to improve outcomes for their clients and margin for themselves?
There has also been an ongoing debate regarding the benefits that HFTs bring to liquidity provision. Detractors point to the potential for increased risks in volatile markets, or evaporating liquidity when market conditions are unfavourable. Supporters emphasize the benefits of increased liquidity, tighter spreads, and lower transaction costs. Either way, HFTs have undoubtedly become an important and permanent fixture of the post MiFID II landscape. This raises a dilemma for regional and smaller sell-side firms who have not traditionally dealt with HFTs and perhaps don’t have the necessary technical infrastructure. They are now asking themselves whether they are missing an important source of liquidity even as regulators continue to review the role of high frequency trading.
Unforeseen and unintended consequences were an inevitable outcome from such ambitious regulations. Investors and their execution brokers now have access to a rich tapestry of liquidity sources – the value the sell-side brings is navigating this landscape to implement their clients’ trading strategies and provide high quality execution. While this has improved cost of trade through tighter spreads, reduced market impact, or the ability to execute large trades away from lit markets, it has come at a price. Infrastructure costs for accessing markets have been rising since the de-mutualisation of exchanges under the first incarnation of MiFID, but further dispersion of liquidity and more rigid best-execution rules have necessitated significant investment in technology, data centres and networks.
So, in order to succeed, sell side firms need a strategy for accessing liquidity (whether through scale counterparties, liquidity platforms or direct venue connectivity) and a clear understanding of the value they bring to their clients.
As a result, trading technologies that enable an agile and customer centric approach to accessing liquidity and that can deliver the performance levels required to serve end clients, will become an ever greater source of differentiation.