There are broadly two schools of thought about the likely impact on 'dark pool trading' of the EU's MiFID II (markets in financial instruments directive II). At one extreme there are those who say dark pool trading will be impossible once MiFID II takes effect on 3 January 2018.
At the other extreme, there is a feeling that official exemptions and the turning of blind eyes by market players and regulators mean nothing will change. Life in the dark pool trading universe will continue pretty much as normal.
A dark pool is a trading venue where information about orders for assets being traded is not displayed before execution. Dark pools have less transparency than 'lit' exchanges. The latter display aggregated volumes of current orders to buy or sell at different prices.
There is a vast amount of grey in the areas between the black and white extremes in dark pool trading and opinion abounds.
Dark pool trading and dumb money
“I have a feeling that some very clever technical people are making a lot of money out of dark pool trading as here is a lot of dumb money in the financial markets,” says self-styled ultra-digital futurologist Rohit Talwar, suddenly sounding very traditional and analogue.
“I am not sure that dark pool trading benefits the economy and society on a wider basis,” he continues. “Dark pools are not a useful tool for trade and transparency. They are the very antithesis of what open markets are meant to be.
“I cannot see why you would want them for legitimate reasons. It is very hard to see how, if you believe in free markets as the cornerstone of an effective financial services system, you can justify dark pools. They are only relevant if you want to bypass normal markets.”
MiFID II irreconcilable with dark pool trading
Rohit Talwar is, then, very much in the camp that believes MiFID II is irreconcilable with the survival of dark pool trading. As is Silvano Stagni, managing director at Perpetual Motion Consulting and Research who features further below.
But both men are realistic enough to paint a different scenario. “Fundamentally, the minute you lay down rules in the financial services industry, people look for ways to get round them,” observes Rohit Talwar, not the first and certainly not the last to make this point.
“It is not a gentleman's club. There is no thought of customer benefit or ethics. The industry will find a way around the regulation.” He invokes the law of unintended consequences.
Industry will bend the rules
A rule intended to render something simpler and cheaper will make it more complex and expensive. “The industry will bend the rules to transfer risk,” he says. “We will see Wild West behaviour which will make the last crash look like a meeting of Sunday school supervisors.
“Greed knows no limit,” he says, ramming the point home. “Greed, like water, will always find a way round all obstacles in its path. Our regulators and rating agencies have become part of the problem. They are not there to protect any more, they are in collusion.”
If this bleak view of the financial services industry is accurate, dark pools, it seems, will, if anything, become darker rather than lighter. The chances of small investors benefitting in any way seem more and more remote.
Stagni sketches out details for dark pool trading
Silvano Stagni has sketched out details of how the industry will shapeshift in response to MiFID II. New trading venues, changes to the definition of best execution and an obligation to trade liquid instruments on exchange will bring about fundamental changes.
Those who operate a trading platform where clients can trade non-equity instruments will have the choice to register as an Organised Trading Facility (OTF) or to execute those trades through third parties.
Those who run a proprietary trading portfolio will have to register as systematic internalisers (SI). An SI is a financial institution that runs a trading platform where their clients can trade one specific instrument with them.
What an SI does
An SI has to provide a buy and sell quote for the instrument in which it has a licence to be an SI but it is not obliged to maintain a stable and liquid market in that instrument as a market-maker does.
More often than not an SI owns (or borrows) the liquidity in that instrument. Although it is not a synonym of ‘proprietary trading’ it amounts to the same thing.
Most disruptive change
One of the most ‘disruptive’ changes is the definition of best execution. In MiFID I it was “the best outcome for the client”. MiFID II extends the concept to include price, total transaction cost and transaction speed.
Transaction speed is defined as the time elapsed between receipt of the order by an execution venue and actual execution of the order. The likelihood of a transaction taking place within the parameter of the order is also to be taken into account.