Navigating the liquidity landscape: Mifid II, dark trading and true institutional wholesale markets

Trade execution has a direct impact on the performance and profitability of a fund: every cent given away in a risk position fundamentally undermines the overall performance and, consequently, the benefits for the end investor. Meanwhile, the fallout from Mifid II’s unbundling and best execution rules will lead to fragmentation and subsequently a greater choice of trading execution venue.  In order to improve execution performance, therefore, it is paramount for traders to understand where natural liquidity lies in this changing market landscape and how best to access it.

Navigating the unbundled market

Mifid II will bring greater transparency to investment markets, with the overall aim of providing a better deal for end investors. The outcome of the new unbundling rules will see a reduction in the number of large bundled orders sent to investment houses, with research being valued and paid for separately, and execution providers being evaluated on their overall performance. The role and the responsibility of the trader will ultimately change because Mifid II places fiduciary duty to achieve best execution squarely on the shoulders of the buy-side trading desk, as opposed to outsourcing this responsibility to the sell-side as was previously the case under the first Mifid.

This change will then have a direct impact on liquidity formation in the market as institutions gravitate towards venues where they can achieve the best possible execution, likely resulting in a reduced number of execution partners. Data will take on an increased level of importance in this area, in order to analyse and evidence the quality of different execution venues.  These substantial shifts in the liquidity landscape will serve to enhance the role of trader, empowering him or her as an alpha creator.

A trader’s choice: Natural liquidity pools

Whilst the primary exchange undoubtedly holds a critical role in price discovery, it is also important to remember that the portfolio manager’s aim is to get investment ideas (which will typically be very large in relation to liquidity available in lit markets) reflected in the portfolio as close as possible to initiation price. The best way of achieving this is to find ‘natural liquidity’, defined as an extensive pool of institutional investors who are aware of and have a potential interest in buying and/or selling a security. Traders with Large in Scale (LIS) orders interested in finding natural liquidity will usually avoid trading on the primary exchange because of the risk of moving the market, especially against the predominant high-frequency traders in this arena eager to shave off basis points. In this scenario, dark pools can provide natural liquidity and avoid the trader assuming a risk position.

Growth of LIS: Authentic wholesale markets

As part of Mifid II’s aim of developing more transparent markets, trading in dark pools is to be restricted, however, with the introduction of a double volume-cap (triggering bans on certain types of dark trading when a transaction accounts for 4% of the total activity on a single dark venue, or 8% of total trading market-wide). Trades breaching the 4% venue-specific cap will be subject to a 6-month ban on the venue in question, while issues exceeding the 8% market-wide cap trigger a 6-month dark trading ban across Europe.

On the other hand, threshold rules for block orders will also be introduced: qualification for the LIS waiver will vary according to how much the stock has traded (for example, a block of just €15,000 for least-traded stocks, or a block of €650,000 for most-traded stocks). All trades above the LIS threshold are exempted from the venue caps.

The combination of these new rules means that big institutional positions (larger than the market) traded in dark LIS pools will not have an impact on volume caps, nor be included as part of the denominator for the 4% and 8% caps. By way of example, a recent analysis conducted by Rosenblatt Securities Inc found that 74% of the biggest European stocks would have breached the volume caps over a year-long study period. The reality is that if the volume of LIS business were to increase, then the number of stocks breaching the volume caps would conversely decrease as a result.  Indeed, Rosenblatt latterly advises that “the buy side will need to become familiar with venues that don’t face restrictions, such as block-focused dark pools”.

At Liquidnet, we foresee these rules pushing the dark market back into a fully-fledged institutional wholesale market – which is what it was designed for in the first place – where LIS trades are executed with maximum price efficiency, minimum information leakage, and for the benefit of the end investor.  Whilst the mechanism of the volume caps are indeed clunky, we believe they are heading in the right direction – in fact, the market is already naturally moving towards this point as can be seen by the rise in LIS trades. Liquidnet recently published research showing that LIS volumes have more than doubled in the past year, increasing from 5% to 10% of all dark volumes traded which is made up of both multilateral trading facilities (MTFs) and broker crossing networks (BCNs). But when examining MTF markets only, LIS accounted for 22% of all dark MTF trading in the third quarter of 2017, up from 12% during the same period in 2016 according to a report by TABB Group. It is also predicted the market will double again over the next year, accounting for 50% of all dark MTF trading, thereby creating a situation where the wholesale market is genuinely coming together.

Whales vs sharks

The regulators got it right, especially by recognising that liquidity discovery for institutional LIS trading is ideally done away from the blare of volume on an exchange, making it the best approach for protecting end investors. Institutions are dealing with like-minded ‘whales’ in the water, versus the highly nimble, high-frequency ‘sharks’ trying to nibble at any piece of position they have in front of a large order – which is effectively a tax on end investors for the benefit of the high-frequency trading world.

With the creation of proper wholesale markets for institutional trading, empowered traders will need to adjust to the different ways in which liquidity will be formed. New tools are being developed, for example, to help the buy-side trader navigate the new landscape either by delivering real-time strategy recommendations or unlocking hidden liquidity opportunities. This newly transparent scenario will not only enable the trader to search for natural liquidity by utilising new tools, but will ultimately benefit the end investor by protecting all-critical alpha.


Mark Pumfrey is yhead of EMEA at Liquidnet

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