MIFID II and its potential impact on Dark Pools

By: Milad Mohammadai

Recently, the European Union has begun the rollout of its new regulatory package for the financial industry of its member states, MIFID II (Markets in Financial Instruments Directive II). This package is a follow up to the original MIFID I that began the harmonization of financial regulation across the European Economic Area back in 2004. The new regulatory package is intended to promote investor confidence along with increased transparency in the European financial market, with aspects borrowed from the landmark US 2010 Dodd-Frank regulatory package. As we will further explore, much of this regulatory package is aimed at what are known as Dark Pools, private trading forums that are not present on traditional public exchanges such as the New York Stock Exchange or NASDAQ.

First to put things into perspective, MIFID II is a general regulatory package that impacts all financial services firms in the European Union. According to an analysis by Bloomberg analyst Dick Schumacher, MIFID II will encompass a wide range of change in how financial regulation is conducted in the EU. Schumacher writes; “among the changes that MIFID will make over the following years will include, the publication of prices and trades, limits on trading in private exchanges, as well as requiring brokers to secure best prices” (A sort of extension of the fiduciary rule), just to name a few.

These dramatic changes are almost certain to make a big impact on the way European financial markets function daily. The question then arises as to whether this new regulation serves the general good. Proponents and ESMA (European Securities and Markets Authority) claim that it is crucial to ensuring transparency and stability in the European financial market, with a clear indication of this legislation being particularly targeted towards dark pool trading. Dark pools, private trading forums for financial instruments where the price and size of orders are not revealed, have been a subject of much heated debate over whether they pose a threat to the health of the global finance market at large.

Dark pools are used by investors who want to fill large block orders (large security purchases) where they may arrange a much more preferable price than they would otherwise receive on the open market. Large orders filled on the open market are more subject to price swings which may negatively impact the price of the securities. To give an analogy, lets say you went to the flea market to purchase furniture, you come across a seller who wishes to sell you a chair. If you purchase the chair in front of other buyers, other buyers will expect to receive similar prices when they purchase the same product from the seller. However, if you were to quietly negotiate with the seller in the corner and decide on a different price, other buyers may never know that the seller sold you the chair for much less than market value. Therefore you can recieve a more favorable price and the seller is able to obtain a guaranteed sale, where he can continue to sell to other buyers at a higher market price. Critics of dark pool trading claim that dark pools pose a serious hazard to investors as there is increased possibility of predatory trading practices by high frequency trading firms. According to Michael Lewis, author of the bestseller Flash Boys: A Wall Street Revolt, dark pools allow for a wide variety of predatory trading tactics, such as pinging. Investopedia’s Elvis Picardo explains pinging very well. Picardo writes; A high-frequency trading firm puts out small orders so as to detect large hidden orders in dark pools. Once such an order is detected, the firm will front-run it, making profits at the expense of the pool participant. Here’s an example: a high-frequency trading firm places bids and offers in small lots (like 100 shares) for a large number of listed stocks; if an order for stock XYZ gets executed (i.e., someone buys it in the dark pool), this alerts the high-frequency trading firm to the presence of a potentially large institutional order for stock XYZ. The high-frequency trading firm would then scoop up all available shares of XYZ in the market, hoping to sell them back to the institution that is a buyer of these shares”.

Defenders of dark pool trading highlight the fact that dark pools are subject to the same strict regulatory scrutiny as standard exchanges, and that they may be a preferable choice for more sophisticated brokers who manage increasingly diverse portfolios. Additionally, long term criticisms have arisen from investors, and even the UK’s Treasury, who claim such regulation has a negative impact on bond liquidity, however this concern is yet to be explored more thoroughly. Dark pool trading over the past decade has substantially increased, especially in Europe according to data from several brokerages, with shares in European equity markets hovering near 10% since 2010.

The MIFID II regulations will undoubtedly impact the dark pool trading platform. However, it remains to be seen whether investors will increase trading on open exchanges as was the intention of the regulations, or if new infrastructure will evolve in the market that circumvent the barriers erected by MIFID II. Developments are already underway to find ways around the new regulation, including the use of what firms call systematic internalisers (SIs), in which firms serve in-house clients against their own book, rather than against other firms, essentially running their own private exchanges, which is currently a method exempt from most of MIFID IIs regulations. Alex Gerko of XTX Markets Inc. told Bloomberg that in fact MIFID II will only further push firms further toward exploring other forms of dark pool trading such as SIs, forecasting a dark pool market that would rise to even 30% of the market according to Bloomberg’s Will Hadfield. If this becomes the case, MIFID II will only be a temporary roadblock to the work of dark pool traders, and nothing more than another project for compliance departments.

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