New European Union regulations that went live at the start of this year have shifted equity trading volumes to lit venues as intended, but have resulted in higher trading costs according to research from ITG.

The broker analysed more than 25 million algorithmic equity trades in the EU and found that lit volume rose from 64% of total volume in the fourth quarter of last year  to 70% in the first several weeks of 2018. Lit volume also rose again to 74% after the double volume caps came into force on March 12 and dark volume dropped from 23% to 16%.

The first volume caps, published in March by the European Securities and Markets Authority, suspended more than 750 stocks from being traded in dark pools for six months as they exceeded the limit of 4% of total volume on a single venue in the past 12 months and 8% combined across all EU dark pools.

Duncan Higgins, head of electronic products at ITG Europe, told Markets Media there has been a significant increase in volumes on traditional lit markets, especially on stocks that were subject to the caps. For algorithmic trading by institutional investors, lit venue use increased from 58% to 77% according to ITG.

“The regulatory push to boost trading activity on lit markets achieved its goal, but it has also likely subjected European investors to higher trading costs,” added Higgins. “We hope the new picture of realised costs will be considered by policymakers before they make any further changes that limit investors’ access to alternative venues with lower average trading costs.”

Rebecca Healey, head of EMEA market structure and strategy at Liquidnet, told Markets Media there needs to be an industry debate over what regulators intended MiFID II to deliver and the future direction. Esma was scheduled to review MiFID II in 2020 as part of a technical review but due to the UK’s departure from the EU, she said this review is likely to have more political involvement and will be more extensive than previously anticipated.

Healey said: “The desired shift of volumes to continuous lit markets has not been accomplished in the manner certain regulators required.  However the question we need to be asking is why investors do not like trading in continuous lit markets but prefer alternative methods to execute their trades. Until we can resolve this issue, regulators will continually be attempting to catch up with market innovation.”

Review of periodic auctions

Large-in-scale trades above a specified size and trades in periodic auctions on lit venues are both exempt from the MiFID II volume caps, so their volumes have risen and are expected to continue to increase. Last month Esma issued call for evidence on periodic auctions which last for very short periods of time during the trading day and are triggered by market participants, rather than the venue.

Steven Maijoor, chair of Esma, said in a statement: “Using this evidence, we will assess whether they can be used to circumvent the double volume caps and other pre-trade transparency requirements under MiFID II. If Esma comes to the conclusion that frequent batch auction systems violate the spirit and the rules of MiFID II, we will develop appropriate policy responses.”

Traditional end of day auctions on exchanges can last several minutes and they are scheduled by the trading venue while periodic auctions may only last for milliseconds. They can be triggered by collecting trading interest throughout the day and starting a ‘call period’ every time a pair of opposing orders can be matched. Based on those offers an algorithm determines a single ‘uncrossing’ price which maximises the volume of instruments which can be executed at that price. Another frequent approach is to trigger an auction as soon as one order has been submitted.

ITG found that periodic auctions are still only 3% of trading, although that has risen from 1% prior to the introduction of the double volume caps.

Higgins said: “Periodic auctions have been a really positive development as they are a better way of finding liquidity in smaller size. The performance of auctions has been excellent and we hope that the regulators will recognise this as part of their review and hold off making any changes until they can gather more data.”

Best execution

MiFID II also puts greater emphasis on best execution and firms now need to take all sufficient steps, rather than all reasonable steps, to obtain best execution and evidence this process. Healey said MiFID II has led to a significant change in best execution.

“The implementation of the MiFID II best execution mandate has been a painful exercise for some but global asset managers are starting to see the value through optimising execution performance,” she added. “Even if an asset manager has an investment horizon over a five year period, they can still benefit from optimising their entry and exit points for that long-term strategy, otherwise they are merely leaving alpha on the table.”

Higgins said the MiFID II best execution requirements have given traders more reasons to invest in tools that help achieve the best results which is positive for the end investor.

“Traders are using more data and analytics and more firms are looking to automate the placing of small orders,” he added. “In the last two years there has been a significant uptake in the use of the algo wheel concept in order to identify the best performing strategies.”

Barclays has described ‘algo wheel’ as generic term for a set of automation tools that range from pure workflow automation to becoming a critical component in the optimization of transaction costs, broker selection, and experimentation.

Healey said technology investments were previously focussed on the trading desk. “Firms are now changing their approach and are looking at how they can automate workflows to improve efficiency,” she added.

Higgins continued that ITG is about to roll out algos in Europe that use machine learning techniques to trade based on access to historic trade data and training in a simulated environment.

Transparency

MiFID II also aimed to increase transparency through increased regulatory reporting. Higgins said: “If it’s your order, MiFID II has given you more transparency on the venue and type of liquidity being accessed.”

However, he said that for the broader market there needs to be more clarity on areas such as over-the-counter trading and systematic internaliser trade reporting. “Firms are working through issues and they will improve in 2019,” Higgins added.

He continued that overall, he was surprised at the relatively smooth implementation in the first weeks of MiFID II and the subsequent introductions of the double volume caps.

“The industry had done a lot of preparatory work in advance and this clearly paid off,” Higgins added.

Liquidnet produced an article at the  the start of this year, MiFID II D-Day: Reasons to stay cheerful, taking the view that the negative predictions around the implementation of MiFID II had been overplayed.

Healey said:” The financial services industry is very innovative and can adapt, survive and thrive – and we have seen this play out throughout 2018. These are incredibly exciting times for European capital markets. Implementing MiFID II has been challenging but benefits are now starting to emerge.”

Both Higgins and Healey said the industry would like a period of stability before regulators implement further changes. However the Brexit negotiations means that this is unlikely.