Dark trading restrictions set to remain on the regulators’ watch lists

The UK Treasury’s Wholesale Markets Review consultation paper devotes some attention to access to liquidity. In Europe, the review of MiFID II is progressing and like rules are also in scope. Tracking upcoming regulatory changes in the UK, alongside those proposed in Europe, focuses on the different treatments offered in each jurisdiction for the double volume cap on equity dark trading.

To recap, a lit venue is a market where prices are published before any execution. Trading in the dark is when there is no obligation to publish pre-trade information. The prevalence of dark trading has long raised questions about the quality of price discovery and whether it causes a decline in overall market quality. But dark pools are recognized as playing an essential part in today’s financial ecosystem. There are arguments on both sides whether dark trading is beneficial or detrimental to market quality at certain threshold levels. Regulators have debated over the years on the pros and cons of applying market restrictions.

Since the introduction of MiFID in 2007, the concept of the pre-trade transparency waiver is widely accepted. There are 4 types of waivers: reference price, negotiated trade, order management, and large scale. In 2018, MiFID II introduced the consistent application of the existing waivers scheme across the EU, and for equities, it introduced percentage volume caps on some dark trading. The regulator’s new capping mechanism limited the amount of trading that could take place in the dark under the reference price and negotiated trade waivers. The changes came with harmonized trade flagging to help regulators and exchanges count the trade volume attributed to the equity dark limits. There’s currently a 4% volume limit set per venue and an 8% limit set on an EU-wide basis, hence the Double Volume Cap (DVC).

At the time, these changes were viewed as complex to translate into operation. The overall intention was to bring about a shift to lit markets, and when the DVC started to bite from March 2018 onwards, it cut nearly half of the dark turnover in Europe. Around about the same time, there was a boost in periodic auctions, block trading, and Systematic Internalizers as MiFID II-compliant alternatives. This moved away from using certain waivers but did not necessarily bring about a permanent change in market behaviour. Trading desks typically adjusted their trading strategies depending on the DVC status. Today’s statistics on DVC suspensions (as of 06 August 2021) published by ESMA include the total number of ISINs suspended as 370 (330 at EU level and 40 at trading venue level).

After three years in practice, ESMA reviews certain aspects of MiFID II, including the double volume cap. In parallel, the UK regulator is assessing their rules post-Brexit.

After dark trading volumes reach the first limit of 4%, ESMA has observed that the dark trading doesn’t stop. It generally leads to a broader 8% cap. ESMA, therefore, proposes to remove the venue-related cap. Also, ESMA plans to lower the EU level threshold from 8% to 7%, resulting in a single EU dark volume cap rather than the existing double-pronged approach.

The UK proposes to delete the DVC from the rule book instead of tapering the restrictions. They view the 2018 regulatory tool as inappropriate for protecting price formation and see no evidence supporting the DVC. To focus on getting the best outcome for investors, the UK plans to do away with the DVC altogether. In their markets review, the UK is looking for simpler and less prescriptive regulation.

To ensure market integrity, the FCA would still expect to monitor the level of dark trading in equity markets. Based on actual evidence and in consultation with stakeholders, we could potentially see appropriate limits being reintroduced in the UK in the years to come.

For the pan-European trading desk, this means that multi-entity and multi-jurisdiction support in one platform remains important as the regulatory landscape evolves.