INTRODUCTION

DOUBLE VOLUME CAPS – DVC On Monday September 28th 2015 ESMA published its final technical standards on MiFID II, Market Abuse Regulation (MAR) and the CSD regulation (CSDR). One of the most controversial legislations concerns equity market transparency, the so-called Double Volume Caps (DVCs) on dark pool trading. The DVCs aim to limit the trading in non-displayed liquidity (i.e. dark pools) by capping the use of two transparency waivers, the Negotiated Trade Waiver (NTW) and the Reference Price Waiver (RPW) as follows: > A venue cap of 4% and a global cap of 8% on usage of the Negotiated Trade Waiver (NTW) and the Reference Price Waiver (RPW). > Only NTW trades, in stocks categorized as “Liquid”, will be subject to the cap calculation. The DVC is not the only limitation that affects dark pool trading. Others include: > The bid/offer option in the RPW as reference price will be removed (only mid-price will be allowed). > The NTW can no longer be used for “automated trading”. However, trades exceeding the Large in Scale threshold can be reported under the LIS waiver to avoid inclusion in the cap calculation. This proposition has been heavily criticized for going too far. The ability to trade non-displayed liquidity is important when aiming to reduce implicit execution costs. Furthermore, there is still no clarity on how the DVCs will work in practice. The following examples focus on the Negotiated Trade Waiver, a model of trade reporting commonly used in Sweden, Finland, Denmark, the UK and some continental exchanges.

Faced with the reality of the Double Volume Caps, market participants must choose a path forward. While the effects of the DVCs are not yet known, it is clear that investment firms now have several theoretical and practical options. These include: > To trade in the lit book. Instead of crossing two agency orders, each order is sent to the lit book for execution at the bid (the sell-order) and the offer (for the buy-order). While this is the regulators’ preferred choice, market participants will probably choose this as a last resort, due to the expected major market impact. Buyer and seller share the spread cost, instead of trading within the spread with no associated spread cost. > To wait until order volume is aggregated and the LIS threshold is reached. In this case, the LIS waiver would (theoretically) make it possible to trade report, even if the instrument is capped. However, the Technical Advice [ESMA/2014/1569] states that “…ESMA should explicitly specify that aggregation of client orders should not be used for the purpose of artificially creating a total order size that results in an order size which falls above that large in scale (LIS) thresholds and therefore can be executed without full transparency”. > To trade OTC. One of the goals of MIFID II is to move trading from the OTC space to regulated venues. OTC trading will still be allowed, but not on a regular and frequent basis. The regulators have been very clear in their communication that the OTC alternative must not be used to circumvent the DVC. > To hope for a new, yet unknown innovation, such as BATS Chi-X elegant model for periodic auctions, to reduce the risk that the caps are hit. The industry will certainly expect new innovation, but the regulators will be watching out for any attempt to circumvent the caps. > To use a Systematic Internaliser. This might be an effective way to mitigate the caps — in specific cases. This paper aims to analyze and explain each of these options.

MIFID II/MIFIR LEGISLATION

MiFID II and MiFIR bring a massive amount of new legislation that impact market models and the competitive landscape. It is not enough to analyze the effect of the DVCs alone; it must be analyzed in parallel with other areas of the legislation.These include: TRADING OBLIGATION The regulators intend to force equity trading to regulated venues and significantly reduce OTC trading. This is expressed in the trading obligation [EU 600/2014]. > ”Article 23 of the Regulation requires investment firms to undertake their transactions in shares admitted to trading on a regulated market on an MTF or a Systematic Internaliser or an equivalent third country trading venue, unless the transaction is > non-systematic, ad-hoc, irregular and infrequent OR > carried out between eligible and/or professional counterparties and do not contribute to the price discovery process”. Unfortunately, legal uncertainty remains concerning the exact thresholds, since ESMA does not have the mandate to specify these thresholds. The RTS from September 2015 [ESMA 2015/1464] notes that this area ”would benefit from further clarity”. However, the regulator’s intent is clear: > “Investment firms must therefore undertake all trades (i.e. on own account and on behalf of clients) on a regulated market, MTF, Systematic Internaliser or third country venue recognized by MiFID unless there is a legitimate reason for them to be concluded outside of such platforms”. [Article 23 MiFIR 600/2014] > “Such an exclusion from that trading obligation should not be used to circumvent the restrictions introduced on the use of the reference price waiver and the negotiated price waiver or to operate a broker crossing network or other crossing system”. [Article 23 MiFIR 600/2014]

SYSTEMATIC INTERNALISER (EQUITIES)

The main rule is this: everything that is traded towards own proprietary capital should be classified as Systematic Internalisation, unless the trade is executed on an RM, MTF, OTF, or if it is traded on an occasional, ad hoc or irregular basis (in that case classified as OTC). ESMA’s Technical Advice to the commission [ESMA 2014/1569] clarifies their view on which thresholds would require a Systematic Internaliser (note that these thresholds are not yet finalized): > Frequent and systematic: 0,4% of the total number of trades or that particular (liquid) instrument within EU. AND > Substantial: 15% or more of the firm’s total trading activity for this instrument or 0,4% of the total trading activity for this instrument in the Union. If an investment firm reaches the thresholds above, it will be obliged to: > Publish two-way quotes on a continuous basis for liquid stocks (otherwise disclose “on request”). > The quoted volume should be: 10% of SMS. > The quotes can be published through a RM, APA or through proprietary arrangements. > Prices should be “machine readable”. > Prices “reflecting prevailing market conditions”. > Prices should be “available at all times”. There is still uncertainty regarding: > Usage of risk-less principal. > Should the SI follow the tick size rules? > Must the prices be electronically tradeable?

TICK SIZE

When MiFID II applies in January 2017, the tick size rules will be governed by ESMA. The same rules will be implemented through all EU markets. Today, the tick size table used in Europe is fragmented. Typically, the liquid (index) stocks use either the FESE-2 tick size table (Nordic countries, Italy and Switzerland) or FESE-4 (Xetra, Wiener Börse, Euronext and Spain), with the less liquid stocks using local tick size tables with a wider tick size. The chosen model will rely on metrics based on the average number of trades per day on the “most relevant market in terms of liquidity” (in practice the primary market).

For the markets using the FESE-2 model (such as the Nordic, Swiss and Italian markets), the new rules will lead to lower tick size, whereas the markets using FESE-4 (such as the German and Austrian markets) will get higher tick sizes. Tick Size Effects for Swedish stocks Defined as “Liquid” in MiFID II Defined as “Non-Liquid” in MiFID II Lower tick size 44 99 Equal tick size 36 72 Higher tick size 14 52 The period for calculating “number of trades” will be one year, from January 1st to December 31st. Since the number of trades is volatile, the actual number of stocks that will have a changed tick size may differ slightly from the above. Christer Wennerberg 5 The tree map below shows stocks with higher tick size in green, lower tick size in red. The size of the square indicates turnover volume for each stock. The RTSs state that tick size rules will be implemented for “Trading venues”. This leaves the Systematic Internaliser without clear rules. This can mean that tick size rules do not apply for SIs, or that ESMA is considering this outside their mandate. There might be local implementations later. A Systematic Internaliser regime without tick size rules will have profound effects on market structure as it will “force” orders to the SIs, the same way that orders were “forced” to the venues with the lowest tick size during the “tick size war” of 2010.

LIQUID MARKETS

The definition of “liquid markets” (i e “Liquid stocks”) is important because it governs the rules for: > Negotiated Trade Waiver cap. Only stocks that are considered having a “liquid market” are contributing to the cap calculation. > Systematic Internaliser quoting requirements. The requirements to post two-way prices are applicable for “liquid stocks” only. The table below illustrates how to calculate if a share is considered “liquid”. In MiFID II, both the levels and the operators (AND/OR) have been changed. Definition – Liquid market MiFID II (MIFID I) MiFID II (MIFID I) Free float 100 MEUR (500 MEUR) AND (AND) Traded daily YES (YES) AND (AND) Number of trades 250 AND (OR) Avg daily turnover 1 MEUR (2 MEUR) 2 MEUR The area of the squares represents the value of the turnover. The color illustrates whether the tick size will be lower (red), higher (green) or unchanged (white).

LARGE IN SCALE

If the volume of an order or trade exceeds “Large in Scale”, the following applies: > An order with volume ≥ LIS can be non-displayed in the order book (of the trading venue). Example: “hidden orders” in Nasdaq Nordics INET trading system. > A negotiated trade with volume ≥ LIS, does not contribute to the double volume cap volume for that instrument. > Orders exceeding the LIS value can be waived from the Client Order Handling rule [ESMA 2014/1569] obligation, i e there is no requirement on the investment firm to submit the order to a venue “with no delay”. > Trades ≥ LIS may not, according to FCA, be included in the calculation of the Double Volume Cap (not confirmed in the regulatory documents).

IS THE SYSTEMATIC INTERNALISER THE ANSWER WHEN THE DOUBLE VOLUME CAPS ARE HIT?

We will now use two examples to test the hypothesis that the SI regime is a way to mitigate the negative effects of the DVC. The examples have a Nordic market perspective since this region uses the NTW as the main trade reporting model, but the hypothesis is applicable to non-Nordic markets as well. The examples are: > An investment firm engaging in client facilitation for institutional clients. Today, the trade following the risk price deal is manually reported to the market, using the NTW. > An investment firm engaging in “traditional brokerage”. In this case, two agency orders are crossed, followed by a trade report using the NTW. A decision tree illustrates the options available to an investment firm to handle the caps. The first five steps are identical in both cases. 1) IS THE TRADE CONTRIBUTING TO PRICE DISCOVERY The Trading obligation (Article 23(3) of MiFIR) states that there is an exemption from reporting a trade on a regulated venue if the trade is not contributing to price discovery [EU 600/2014]. Trades that are eligible for this exemption are “administrative transactions” and hence not interesting in the context of the DVCs. Nearly all trade reports will pass this test with a “YES”. However, it is important to analyze this case further and look for possible attempts to use loopholes in the regulation.

IS THE TRADE REPORT DONE IN A LIQUID STOCK?

As described above, the new definition of Liquid stocks (“Liquid markets”) will most likely result in more stocks deemed to be “Liquid”. One example is the Swedish market, where currently 75 stocks are deemed liquid. With the new definition, more than 90 stocks will fall into that category. SE DK FI NO EU 2015 Number of liquid stocks 55 24 26 25 904 2017 Number of liquid stocks 94 31 31 37 1138 Those stocks will equal > 94% of the turnover. The rules for the Double Volume Caps state that only Liquid stocks should be hit by the cap calculation. In practice, this rule will be of little value since only around 5% of the turnover will be exempt from the DVC. 3) DOES THE TRADE REACH THE LARGE IN SCALE THRESHOLD?

IS THE INSTRUMENT SUBJECT TO A SUSPENSION OF THE NTW AND RPW DUE TO THE DOUBLE VOLUME CAP?

If the DVC threshold of 4% is reached, the usage of the NTW and the RPW is suspended for 6 months on that venue. Until the EU-wide cap of 8% is reached, dark pool trading and negotiated trade reporting, using the RPW and the NTW, will be transferred to a venue where the cap is not (yet) reached. When/if the 8% cap is reached, no usage of NTW and RPW is allowed in that particular instrument. In order to have the metric ready for January 3rd 2017, the venues have been requested to start to measuring and reporting to their competent authorities as of January 2016. One can discuss different challenges and problems due to lack of trade type and waiver categorization standards, but it is likely that usable data will be available by January 2017. Looking at the data at hand, it is very likely that DVCs will reach the threshold of 8%. Currently, the average trading in dark pools for the most liquid indices are as follows: Dark % FTSE 100 10,38 CAC 40 7,14 DAX 5,99 OMXS30 8,78 OMXC20 9,45 OMXH25 9,26 OBX 8,61 ATX 6,00 Source: BATS trading (1/1 – 1/10 2015) All else equal, the caps will be hit from day one of MiFID II for most of the benchmark instruments. However, the term “all equal” is not a given. There are some challenges involved in estimating what will happen when MiFID II takes effect. Two dimensions must be analyzed: > Before and after MFID II > The static vs the dynamic view The static view relates to how to categorize and report the volume eligible for the DVC. It involves challenges such as: > The rules for dark pool trading and negotiated trades differ between the measurement period and the period after MiFID II applies. During the 2016 period, there is no strict Trading obligation in place, which means that no dark pool trading in the OTC space will be included. Another local example is Denmark, where a lot of the trading reported under the NTW will have to move to the Systematic Internaliser regulation after MiFID II applies, since it is in practice trades done under the Systematic Internaliser regime (the Danish “Strakshandel”). > After MiFID II applies, dark pool trading (<lis)  How will the investment banks and venues adapt before MiFID applies? There are already activities that will affect the period before MiFID II applies. One example is BATS’ continuous auction, an innovative way to offer an alternative to the traditional dark pools. It is likely that some dark pool trading will move to BATP (which is the MIC for the new market), and thus reduce the risk that the DVC thresholds are reached in some stocks.

On the day that MiFID II applies, the trading in a number of instruments can no longer benefit from the NTW and the RPW. A larger portion will probably move to alternative market models, such as BATS’ periodic auction. The larger institutions will move some of their trading to dark pools to benefit from the LIS-waiver. This may lead to a more two-tiered market than today (probably not the regulators’ intent). > The MTFs that will find themselves close to hitting the cap will probably stop the usage of the waiver before they are asked to do so by the regulators. No MTF wants to be the first to suspend the usage of the cap. Will they start performing temporary shutdowns during 2016 to avoid suspension in 2017? > The cap is calculated for each trading venue, i e for each Market Identifier Code (MIC). Interestingly, BATS/Chi-X have four different MICs, each with a capacity to trade up 4% (!). > An important aspect of the DVC is the question “what happens after the suspension is lifted?” It is not obvious that the order flows return to the situation before the cap resulted in a suspension of the waivers. If some of the flow is moved to Systematic Internalisers after the caps are hit, it is not unlikely that the SIs will keep a substantial part of the flow after the caps are lifted.

THE CLIENT FACILITATION CASE

This example describes a (Nordic) investment firm that has conducted a client facilitation trade, with volume “Such an exclusion from that trading obligation should not be used to circumvent the restrictions introduced on the use of the reference price waiver and the negotiated price waiver or to operate a broker crossing network or other crossing system”. MIFIR 2014/65 Using the OTC option in this case will cause trading to move from regulated venues (using the NTW) to OTC. This is clearly not what the regulators intended. Unless a completely new market model innovation emerges to resolve these challenges, the investment firm will have no other option than to use its own Systematic Internaliser, if it wants to maintain its client facilitation business.

THE AGENCY TRADING CASE

This case resembles the one above, but involves two client orders instead of one. This example should actually not have come this far, at least not with the alternatives currently at hand. It is not possible to report a negotiated agency trade if all options have been exhausted. Instead, the clients should already have been notified that their orders could not be crossed. They need to let their orders be traded in the lit order book (which is exactly what the regulators wanted to achieve with the DVC).

TICK SIZE

In this case, tick size is crucial. Unfortunately, it is still unclear whether tick size rules should be applied in an SI (ESMA has no mandate to decide). However, some trading venues have lobbied extensively that the absence of tick size rules will lead to the circumvention of the trading obligation. Let’s assume that there will be no tick size rules. In this case, it is possible for the SI to execute two principal trades on process close to mid-price (this also assumes that price improvement will be allowed on a larger scale).

STRETCHING THE BOUNDARIES

There is massive legal uncertainty surrounding the SI, the most important of which is the “risk-less principal” question. ESMA does not have the mandate to decide whether the risk-less principal should be allowed in the SI, but they have been very clear that do not believe that it should since it might result in situation where a “synthetic” Organized Trading Facility could be set up. If this were to be allowed, we would have a situation where agency orders can meet other agency orders (just passing through the principal account), and at the same time principal orders could meet agency orders. In that case, we would have the same situation as today with the Broker Crossing Networks (“broker dark pools”). This situation would clearly be in conflict with the intentions of MiFID II, and is hence very unlikely.

CONCLUSION

Let’s assume that the investment firm does not reach the thresholds to be automatically deemed as an SI. It is very risky to draw the conclusion that it unnecessary to become an SI. That conclusion is based on the assumption that a new market structure will emerge and eliminate the risk of the NTW and PRW reaching the caps. Even if new market models, such as the BATS periodic auction, will reduce the risk of ALL benchmark stocks hitting the caps, many instruments will still suffer from suspended usage of the caps. An investment firm does not have the option to say to its clients “you can trade any stock with us, as long it is not subject to the DVC.” Furthermore, there is a significant risk that the liquidity in the order books will suffer from the new regulation: > Tick-size changes (a reduction of tick size will reduce value of time priority). > Market maker obligations and compliance impacts that will restrain liquidity providers to continue provide liquidity. > Order flow will move to LIS dark pools due to the Double Volume Caps. This will likely result in the emergence of new Systematic Internalisers that will offer an alternative to the order books on the trading venues. Since there is a risk/chance that no tick size rules apply for Systematic Internalisers, one possible scenario resembles the effects of the “tick size war” that led to implementing FESE-2 and FESE-4, i e the order flow is “forced” (due to Best Execution requirements) to the venue with the tightest spreads. This may also lead to a two-tier market since it is possible to treat different client categories within a Systematic Internaliser. So, “Do I need to be an SI if I don’t reach the SI thresholds?” — “NO!” But “Do I need to be an SI if I want to remain competitive?” — “YES, I do!”