European Union efforts to bring greater transparency to stock dealing risk having the opposite effect, forcing regulators to intervene once again after new rules come into force in January. Overall, European regulators want to promote an orderly market following the financial crisis, when opaque trading led to disaster, and ensure small investors get a fair deal.
So the EU's Markets in Financial Instruments Directive, or MiFID II, aims to push more trading onto regulated public exchanges where prices and participants are visible to all. But some investors seeking anonymity and lower fees are likely to opt instead for "systematic internalisers" - dealing platforms run by banks and other market participants which reveal much less information about impending transactions.
Market participants say institutional investors who mostly use the established exchanges, such as the London Stock Exchange (LSE), may be tempted to follow suit for some business. The longer-term consequences of the MiFID II regime, which applies from January 3, remain highly uncertain and the exchanges are already fighting back with new products to regain business after suffering a sharp drop over the past decade.
Major shifts in European equity trading are on the way due to the regulatory changes. Brian Schwieger, the LSE's global head of equities, estimated that around a third of UK trade will be up for grabs in the New Year. "That's all got to find a new home," he told Reuters. However, Europe's regulated exchanges already have a much lower market share than in other regions, and some people believe this will shrink rather than grow.
"The exchanges will be the losers; not on Day One, but over time," said Michael Horan, Head of Trading at broker Pershing Securities. He predicts the LSE's share of European turnover could fall to as little as 30-40 percent from 50-60 percent now. The original MiFID I, born in 2007, has failed to curtail the growth of "dark pool" trading where dealing is done anonymously, unlike on the conventional "lit" markets.
Regulators' ambition this time is to ensure investors get "best execution", which can mean achieving the fastest, most efficient transaction at the lowest cost for clients. Another aim is for deals on public exchanges to cause minimal price movement, a chief attraction of dark pools. Institutional investors such as pension fund managers and insurance companies putting through a big deal can find the market moves against them when others become aware of the impending transaction. The price can rise before their purchase is executed or conversely fall before their sale goes through.
MiFID II's answer is more transparency to curb market operators' ability to take advantage of private information which can drive up costs for the institutional investors and, ultimately, their clients. It will prevent investment banks from operating private trading networks, which match their clients' buy and sell orders and lump the transactions in with their own proprietary dealing, without routing the business through a public market.
The banks have to re-register these services as systematic internalisers (SIs), which must provide public price quotes for trades of up to the "standard market size". However, MiFID II exempts larger deals handled by SIs, acknowledging investors' desire for anonymity to limit the market impact. Institutional investors, who will ultimately determine where the biggest deals are transacted, are reluctant to say how the changes might affect their trading choices. Amundi, Blackrock, Fidelity, RAM and Vanguard all declined comment for this report.
LSE's Schwieger estimates the banks' private networks currently handle up to a quarter of stock turnover, with the traditional dark pools accounting for a further 10 percent. So with MiFID II forcing roughly 35 percent of total liquidity into other markets, lit exchanges will gain business. "I can't see all of it being swallowed by SIs," he said. Regulators say they will act if their intentions are frustrated. Steven Maijoor, chairman of the European Securities and Markets Authority (ESMA), described greater transparency as one of the new rules' chief aims. "If we see that MiFID doesn't work as intended, we will use our tools to make sure that is corrected," he told Reuters at a recent Regulation Summit.
These tools could include issuing guidelines to promote consistent implementation, or changes to regulatory technical standards, if appropriate, an ESMA spokesman said. An additional element of uncertainty lies in the fact that Europe's biggest stock exchange, the LSE, will cease to be in the EU when Britain leaves the bloc in 2019. However, MiFID II will be incorporated into British law and, as UK regulators were a major force in its creation, significant changes seem unlikely after Brexit.
Europe performs comparatively poorly on transparency: around 50 percent of equity trade is conducted on lit public markets against 67 percent in the United States and 88 percent in east Asia, according to data from the OECD and trading software provider Fidessa.
Turnover on lit order books on exchanges such as the LSE and the pan-European Euronext was 730 billion euros ($850 billion) in September 2017, half the 1.4 trillion euro level of January 2008, data from Reuters Market Share Reporter shows.
UBS exchanges analyst Michael Werner said this drop was partly due to the proliferation of multilateral trading facilities (MTFs), alternative dealing systems born from the first iteration of MiFID. Werner sees the SIs - which will also be run by high frequency traders specialising in huge volumes of small orders with razor-thin margins - taking six percent market share, though due to the uncertainty his top-end forecast is 15 percent.
The regulator has already closed a loophole in MiFID II which would have allowed SIs to hook up to each other to trade. But Better Finance, a group representing European investors, called on ESMA last month to address parts of the rules it says will give SIs an unfair advantage. One selling point for the SIs is they charge no commission fees because, unlike traditional exchanges and MTFs, they make money purely on bid/ask spreads and volumes traded.
MiFID II exempts SIs from rules governing the minimum amount a stock can move for orders larger than standard market size. This means they could offer prices inside the bid/ask spread quoted by the traditional exchanges for certain stocks, lowering investors' dealing costs. Rainer Riess, director of the Federation of European Stock Exchanges, said this price advantage could help SIs attract a greater share of orders, hurting investors overall. "The more you trade away from lit venues and price formation is weakened, the higher the spreads will become and the higher the transaction costs for everyone in the market," he said.
The new rules cap the amount of a company's shares that can be traded in dark pools, and the exchanges are using this to fight back. They are introducing products such as closed intra-day auctions, which mimic dark trading, to attract investors keen to avoid showing their hand in the market. For large orders, exchanges could be more attractive than MTFs as their deep pool of liquidity enables them to offer thinner bid/ask spreads on average, UBS analysis found.
"If you have an order that's 5 percent or 10 percent of the average daily volume, there's a good probability you will have to go on exchange to complete that trade," said Curtis Pfeiffer, chief business officer at trading algorithm provider Pragma.
Recent data indicates exchanges' strategies are working. Market share is strongly up for most European exchanges this year, figures from the US-based market operator BATS show, while lit MTFs have all lost ground. Werner expects most of the dark pool business will go back to exchanges rather than MTFs. Both the LSE and Euronext have launched platforms for trading large blocks of shares in the dark, which are covered by the MiFID II waiver. Ultimately, some investors will always want to hide their orders from the rest of the market.
"This whole 'battle' between exchanges and SIs is only happening because there's a genuine market need for off-exchange liquidity, which is being squeezed by the incoming dark pool caps," said Rob Boardman, CEO of trading platform ITG. Whatever the impact of MiFID II, it is likely to be gradual as participants adapt to the new regime. "There are unintended consequences of every rule. MiFID II is trying to address those but it's almost certain that more will emerge, in which case we will have MiFID 3," said Werner.