The CFA Institute has warned that attempts to remedy systematic internalisers have not worked despite the new venues not increasing transparency as intended under European Union regulations which went live this year.

MiFID II, which came into force in January, banned broker crossing networks. Instead, firms have to set up systematic internalisers in order to provide risk capital that facilitates trades, which brings regulatory obligations such as trade reporting.

The MiFID II regime was meant to allow firms to execute transactions with selected clients in private. Did it? Svi Rosov, PhD, CFA, weighs in https://t.co/OSigTkkwBl

— CFA Institute® Market Integrity (@MarketIntegrity) July 19, 2018

Sviatoslav Rosov, PhD, director, capital markets policy EMEA at CFA Institute, said in a blog this month that the SI regime is problematic. He wrote that it is easy to design an SI with an automated quoting system that has quote feeds from various sources, including other SIs, going into an execution engine that automatically selects the most desirable execution outcome for the client order.

“By connecting to one another to create de facto multilateral trading venues, SIs could essentially recreate broker crossing networks, which MiFID II was intended to prevent,” he added.

The European Securities and Markets Authority tried to close this loophole by releasing a Q&A document covering when SI activities would cross over into operating as a trading venue, so  matched principal trading would still be allowed on an “occasional basis.”

“Whatever the intention, Esma’s clarification did not succeed in dampening the attractiveness of the SI regime,” added Rosov. “Assuming market transparency remains a key concern for Esma, it appears that the outlines of MiFID II are already starting to take shape.”

French regulation

The Autorité des Marchés Financier, the French financial regulator, said in its Markets and Risk Outlook at the beginning of this month that MiFID II’s objective of increased transparency is unlikely to be met given the strategies developed by market participants.

Robert Ophèle, chairman, AMF, said in the report: “It is now time to turn our attention to actually achieving some of the objectives pursued, such as increased markets transparency, at a time when new methods of trading are emerging. We need to analyse these developments.”

The regulator said the increased use of systematic internalisers and periodic auctions is problematic as these new methods of trading are circumventing the double volume caps.

Since MiFID II went live, there are 28 SIs active in French securities, accounting for one-third of total volumes and three-quarters of over-the-counter volumes according to the report. In contrast last year there were 14 SIs active on French securities for a cumulative market share of less than 1%.

In addition, there were 103 SIs in Europe registered with the European Securities and Markets Authority at the end of April this year according to the AMF.

“The pronounced, rapid development of the market share of systematic internalisers following the introduction of the requirement of trading on platforms or SI raises a question about the functioning of markets: is there really an improvement in the pricing mechanism when traded volumes move from pure over-the-counter to systematic internalisers?” added the AMF.

Tim Cave, an analyst at consultancy Tabb Group, said in a report that addressable SI daily notional increased marginally to €14.1bn last month, up from €13.4bn in May.

Where has equity liquidity moved at the #MiFIDII 6 month mark? SIs, periodic auctions and closing auctions, mainly https://t.co/R1VcRLt8Ea via @TabbFORUM

— Tim Cave (@_TimCave) July 18, 2018

He analysed the the first publication of MiFID II RTS 27 execution quality reports in June which are required from all venues and covered the first quarter. Cave said: “This proved what many had predicted: that SI transactions are mainly being undertaken by banks and that electronic liquidity providers accounted for a small proportion of volume.”

Double volume caps

MiFID II also aimed to encourage trading on lit venues by introducing double volume caps on trading in dark pools. The launch of the caps was postponed until 12 March 2018 and 1,487 shares, including 71 French securities, were exempted from transparency according to the AMF.

“Following this implementation, dark volumes decreased over first quarter 2018 from 4.4% of total volumes at the end of 2017 to 3.3% at the end of March 2018,” said the report. “This decline is also observed on other European markets.”

However the regulator noted that the market share of overall lit markets remained almost unchanged at 46%.

“This goes against the initial ambition of the legislators and the forecasts of participants, who anticipated a resurgence of transparent platforms,” said the AMF.

Research from Swiss exchange group SIX in May found that traders disagree over whether MiFID II has been successful. A majority, 70%, said transparency has improved but only one quarter believe dark liquidity will shift to lit markets.

FAiL II? New research by SIX shows traders of the Swiss exchange have contrasting opinions regarding transparency and dark liquidity shifts following the introduction of MiFID II. #MiFID2 #SwissExchange #ExchangeServices https://t.co/hGs69ZUyok pic.twitter.com/OSv0SdfFfH

— SIX (@sixgroup) May 29, 2018

“Traders indicate that they are also divided as to where dark liquidity on capped stocks will shift instead of lit markets, with a relatively even spread between block trading/LIS dark pools (31%), systematic internalisers (23%) and periodic auctions (20%),” added SIX.

So far under MiFID II, dark volumes appear to have moved to negotiated trades reported to platforms and to a lesser extent, periodic auctions.

Auctions

Cave said periodic auctions volumes were 2.6% of total order book trading in June, just above 2.5% in May.

“Venues run by Turquoise, Goldman Sachs’ Sigma X, ITG Posit and Nasdaq all saw a pick-up in volumes, while UBS MTF launched its periodic auction on June 18, becoming the sixth in the market,” he added. “But Cboe Europe still accounts for the lion’s share of periodic auction activity, trading volumes worth €1.1 bn.”

June was another record month, with Turquoise Plato Block Discovery's biggest ever trade and €1.22bn traded through Turquoise Lit Auctions @tradeturquoise https://t.co/D8aKYBKblx pic.twitter.com/lYP5yBz3HB

— Plato Partnership (@PlatoMarkets) July 11, 2018

The AMF warned about the rise in volumes of periodic auctions. “While this trading protocol theoretically offers pre-trade transparency, it actually appears to be below the transparency level of lit platforms and could constitute a circumvention of the double volume cap ban,” said the regulator.

However Cave noted that the UK’s Financial Conduct Authority said last month that periodic auctions are not yet a major feature of the overall equity trading landscape. “The FCA encouraged market participants to continue to adapt to the new trading landscape and venues to continue innovating new solutions,” he added.

Cave continued that electronic large-in-scale trading, which has a waiver from the double volume caps, hit record levels in May and then fell back slightly in June. LIS trading was nearly half, 48% of Europe’s dark trading market and around €1.2bn on a daily basis. “The block market continues to concentrate among four players: Liquidnet, ITG Posit, Turquoise Plato Block Discovery Service and Cboe LIS,” he added.

€1.3 billion traded on Cboe LIS last week, making it our second-best week on record. #blocktrading #largeinscale #MiFIDII pic.twitter.com/PqqKoD6GS1

— Cboe (@CBOE) July 16, 2018

The AMF questioned the development of LIS trading and said some participants are waiting to aggregate enough small orders to maintain their ability to trade on dark platforms once the waiver size is reached.

The regulator warned: “This behaviour of postponing the execution of a client order in order to reach a LIS size that bypasses the double volume cap could directly harm the execution quality of client orders and violate the best execution obligation.”

Cave also noted that one of the untold stories under MiFID II has been the increasing popularity of closing auctions. He said : “Closing auctions now account for nearly one-fifth of trading in European equities on a daily basis.”