Tough new European regulations limiting the scope of “dark pools” are prompting stock exchange operators to develop equivalent systems to fill what is expected to be a gap in the equity market.
With just over a year to prepare, operators of dark pools — private trading platforms that ensure anonymity for institutional investors who want to place large orders without moving the market — have begun testing alternatives.
They include “semi-dark” stock auctions and services to deal with larger-value orders, which will be exempted from the new rules.
The reform they aim to cater for is part of MiFID II, the second Markets in Financial Instruments Directive, taking effect in January 2018 and designed to make EU financial markets more transparent, competitive and secure.
Institutional investors who often trade large blocks of shares have embraced dark pools.
But EU regulators have argued that dark venues tend to make markets less efficient and less transparent, particularly affecting smaller or less sophisticated investors.
Under MiFID II, global “dark trading” volumes will be limited to 8% of total average daily volumes for individual stocks.
In the 12 months to September, dark trading in between 80 and 90% of stocks in Britain’s blue-chip FTSE 100 and mid-cap FTSE 250 indexes was above that limit, data from Bats Europe — the largest European stock exchange by value of shares traded — showed.
In June trading volumes across European dark pools topped €100bn for the first time.
“Dark orders will need a home once the double volume caps come into play,” said Bats Europe CEO Mark Hemsley. “It’s up to market operators to develop new initiatives to help investors find liquidity and trade large quantities without the associated market impact.”
At present, dark pools have no trade size or volume restrictions, but under the MiFID reforms only large-in-scale orders — defined as worth between €15,000 and €650,000 depending on the traded stock’s average daily turnover — will be permitted.
In response, Bats Europe plans to launch Bats LIS, a new block trading service, this year.
Pan-European exchange Euronext is also trialling a large-in-scale service due to go live in early 2017.
The LIS waiver is designed to protect large orders from an adverse market impact and to avoid abrupt price movements that can cause market distortion, law firm Norton Rose Fulbright says.
The new initiatives also include ‘semi-dark’ auctions that match buyers and sellers while publishing limited information related to volumes and prices.
BATS will cover that option with its Periodic Auctions book, launched last October and operating auctions throughout the day.
The London Stock Exchange Group, meanwhile, is focusing on its daily midday auction, when trading at the exchange halts for two minutes to allow participants to place orders confidentially.
Its Turquoise Plato Block Discovery platform is already MiFID-II compliant and has saw more than €1.5bn traded in the six weeks to October 18, according to the exchange.
An LSEG spokesman said it was not unreasonable to assume that lit venues — where trading volumes and bid and offer prices are displayed transparently — may benefit from the reforms.
But it was not relying on this and was working on providing new services well before January 2018.
Some experts say MiFID-II is likely to see another set of venues emerge much like what happened in the run-up to the implementation of MiFID I in 2007.
“Users of dark pools have a choice of dark or lit venues in line with performance objectives,” said Nej D’jelal, EMEA head of Electronic Equities Product at Barclays.
“The reason we don’t presume that liquidity will automatically move to lit venues is because there will still be a lot of competing venues such as systematic internalisers, auctions and block discovery platforms targeting that volume.”