MiFID II Requires Smart Liquidity Aggregation

Shanny Basar

Decisions on liquidity aggregation and smart order routing will become more important when new regulations affecting market structure come into force in the European Union next year.

Instinet, the broker owned by Nomura, said in a white paper, The Impacts of a New Liquidity Paradigm, that decades of regulatory upheaval have created a patchwork of exchanges, multilateral trading facilities, over-the-counter liquidity providers and dark pools in the European Union.

However MiFID II, the regulations coming into force in January 2018, will change market structure by creating new types of venues and placing caps on trading in dark pools. In addition, the buyside is required to take ‘sufficient’ rather than ‘reasonable’ steps to achieve best execution, and to be able to provide evidence to show how this have been achieved.

“Advances in technology and the introduction of MiFID II are now redefining roles and expanding the relationships between participants,” added Instinet. “As a result, smart aggregation and the creation of personalised liquidity pools are creating the opportunity for trading experiences as individual as pages on social media.”

Instinet continued that the changes in the trading landscape under MiFID II could be as stark as London’s Big Bang in in 1986 which eliminated the role of jobbers and radically redefined the role of stockbrokers.

“This time, it is the role of trading venues and institutions that will be transformed, as both clients and liquidity providers benefit from the ability to target liquidity and pricing down to the individual strategy level,” said the white paper.

As a result, investors will have to pro-actively manage more highly tailored real-time data to meet their liquidity needs. Instinet said traditional measures such as weighted average price will no longer be good enough, and market participants will need to deploy scientifically robust methods to ensure adequate sample selection and statistically sound results to satisfy the best execution requirements.

“The pricing power of proprietary traders will create a range of liquidity options, which will re-arm and empower institutional clients,” added Instinet. “However, thriving in a more tailored, individualised world will require managing a vast array of data, deploying well thought-out trading strategies and cultivating new industry partnerships.”

MiFID II also eliminates broker crossing networks and extends the role of systematic internalisers for firms that provide capital for trading.

Systematic internalisers were originally set up for equities under MiFID in 2007 for all off-venue trading in the European Union. However only nine banks became SIs and very few trades took place on the back of an SI quote as off-venue trading moved to broker crossing networks. MiFID II makes it compulsory for firms committing capital on a frequent basis, or that accounts for more than 0.4% of trading in a stock, to register as an SI. They will have pre-trade transparency requirements and must continuously publish competitive, two-way quotes up to the standard market size for each stock.

A survey from consultancy Tabb Group this month found that 60% of buyside institutions expect to use SIs from the start of MiFID II, albeit tentatively, as they review execution quality analysis.

“Of those who said they would not use the regime, most said they planned to make an assessment of SIs in the second half of 2018, once more data was available on execution quality,” added Tabb. “This limited usage initially, combined with restrictions on dark pools, implies activity will shift back to lit markets during early 2018.”

Tabb estimates that up to 20 equity SI operators will be registered when MiFID II comes into force. As a result of the liquidity fragmentation, 70% of respondents said they would use broker smart order routers to sweep multiple SIs, rather than connecting to each individually.

Investment banks will offer liquidity in larger size while electronic liquidity providers will offer market-making strategies directly to clients for smaller-sized orders. “In reality, only a handful of these SIs will offer competitive prices,” said the report.

Therefore, nearly half of buyside institutions expect their broking lists to shrink under MiFID II.

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