Pre-trade transparency obligations are placed on both RMs and MTFs by MiFID for shares listed on regulated markets (for SIs a specific system of quotes publication applies)68. The Directive, however, acknowledges the risk of market impact caused by transparency obligations for certain types of orders and trading venues. In response to this, regulators have introduced a list of exemptions in specific cases. In particular, MiFID recognises pre-trade transparency waivers for market models and for orders of a certain type or size. However, dark trading may deteriorate market quality if it reaches an undefined overall size. Empirical evidence does not provide a clear answer – either on whether a threshold for dark liquidity and waivers would capture the critical point – or on where this overall threshold should be placed, whether by regulators or the market. Therefore, waivers of pre-trade transparency should be constantly monitored and updated as soon as market developments make it necessary. CESR (2010b) is thus proposing a more rule-based approach, with ESMA defining binding technical standards and ongoing supervision in line with the new powers as new European authority.69
According to MiFID,70 there are four kind of waivers: 1) Reference price;71
2) Large in-scale orders (LISO);72
Definition
66 “It is not the intention of this Directive to require the application of pre-trade transparency rules to transactions carried out on an OTC basis, the characteristics of which include that they are ad-hoc and irregular and are carried out with wholesale counterparties and are part of a business relationship which is itself characterised by dealings above standard market size, and where the deals are carried out outside the systems usually used by the firm concerned for its business as a systematic internaliser.”, Recital 53, MiFID. For more details about OTC trading venues, please see Section 5.4.
67 For a more detailed discussion, see Section 4.4.
68 In particular, SIs should publish quotes for liquid shares if executed orders are below the Standard Market Size (SMS); Art. 27, MiFID; Art. 21-25, Implementing Regulation.
69 Art. 6 (1) (a), (2) (a), Art. 7 and 7e, adopted position at first reading by European Parliament on 22 September 2010, (http://www.europarl.europa.eu/sides/getDoc.do?pubRef=-//EP//TEXT+TA+P7-TA-2010-0339+0+DOC +XML+V0//EN#title3).
70 For a detailed overview of the MiFID waivers (with examples), see CESR (2010e) and Moloney, N. (2008), pp. 826-830.
71 Art. 18.1 (a), Implementing Regulation. This waiver applies to trades that are crossed at a price generated by another trading venue. In this case, the trading venue uses prices of more liquid pools of liquidity in order to avoid risks of non-reaching the ‘critical mass’ of liquidity. CESR (2010e), p. 3.
3) Negotiated trades;73 and 4) Order management facility.74
Those waivers serve multiple functions:
i) Stimulating price competition (improvements) and containing information leakage (reference price);
ii) Protecting orders from market impact (LISO); and
iii) Ensuring the smooth functioning of capital markets and execution services (negotiated trades and order management facility).
Overall, waivers aim at reducing the exposure risks that may affect market quality and integrity. Well-functioning financial markets allow the efficient allocation of resources and thus the increase of total welfare for all end investors.
The reference price waiver applies to RMs and MTFs given the importance of alternative dark trading venues, when it comes to competition on trading costs and potential price improvements. Those venues are typically MTFs that try to offer protection from information leakage and market impact at competing prices, with no price discovery (passive pricing system). European trading under reference price waivers has been estimated around €25 billion in the Q1 of 2010, 5 times more than in the same period of 2009, but only accounting for 1% of total trading on RMs and MTFs (see Figure 10). As abovementioned, the presence of alternative dark venues can improve market quality and stimulates new flows of liquidity with beneficial impact on investors’ choice and competitiveness of trading venues. This waiver is designed for venues willing to offer lower trading costs and potentially price improvements in relation to the ‘referenced’ venue. Orders should be executed at mid-point of the bid/ask spread of the primary market or at mid-point or best bid or best ask of the European Best Bid and Offer (EBBO), as currently established by CESR (2010e). However, market participants have conflicting views on this issue. They are split between those who would set a specific threshold (individual/aggregated) for orders size that use this waiver or capping the volumes regarding trading under waivers), and those who would leave to the market the decision on how many trading venues should use this waiver with the obligation for these venues to provide price improvements in exchange for the waiver.
Reference price
The former group, in effect, implicitly proposes to set a threshold (e.g. a percent of Large-In-Scale Orders;75 Fleuriot, 2010) that de facto makes this
Market views
72 Art. 20, Implementing Regulation. The waiver applies to orders equal or above a minimum size specified in Table 2, Annex 2, Implementing Regulation. The calculation of the ‘normal market size’ should be made using the average daily turnover, which shall be calculated as defined by Art. 33, Implementing Regulation. CESR (2010e), p. 17.
73 Art. 18.1 (b), Implementing Regulation. Specific conditions apply to negotiated trades that avoid pre-trade market transparency as they are subject to different conditions than ones currently offered on public markets. CESR (2010e), p. 11.
74 Art. 18.2, Implementing Regulation. This waiver applies to orders held in an order management facility (or ‘Reserve’) run by regulated markets or MTFs, which have the potential to be introduced in the order book to be executed – for instance – against incoming aggressive orders. CESR (2010e), p. 14.
75 As defined by Table 2, Annex II, MiFID Implementing Regulation; for the purpose of determining the size of large-in-scale orders, the average daily turnover is defined by Art.33, Implementing Regulation.
waiver available only to a type of orders (large ones) disregarding the type of trading system (as also pointed out by some CESR members; CESR 2010b). In their view, MiFID foresaw waivers to limit market impact of large orders and price hence should be limited to the mid-point as only at that point of the spread would justify those orders not to contribute to the price formation process. Against this view, other market participants argued that this waiver was originally designed to favour competition on explicit and implicit trading costs between dark and lit books. In their view, therefore, these venues should be allowed to match orders within the spread of primary markets or EBBO, with the guarantee of a price improvement. It is important to ensure a price improvement when the price comes from another system. A limitation based on size of orders – in their view – would harm the market, as no longer small or ‘child’ orders (of large ‘parent’ orders76) will be traded ‘dark’, with no protection from information leakage and so exposure risks. In addition, this waiver currently captures only a small fraction of the market (1%).
Figure 10. Current use of waivers
0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 0 20 40 60 80 100 120 140 160 180 Q1/08 Q2/08 Q3/08 Q4/08 Q1/09 Q2/09 Q3/09 Q4/09 Q1/10* Negotiated Trades (€bn) LISO (€bn) Reference Price (€bn) Negotiated Trades (%) LISO (%) Reference Price (%) Source: CESR (2010b).
The Large-In-Scale Order (LISO) waiver applies to orders that are bigger than special thresholds set by MiFID for each defined liquidity band (average daily order book turnover, ‘ADT’).77 It tries to soften the exposure risk of large orders, which may generate market impact. It is largely used by MTFs and RMs (for their hidden orders pools). As suggested by the literature review above, hidden orders increase the quality of lit books as they attract liquidity from large traders and informed traders, who try to act more aggressively in order to capture this new liquidity flow. Therefore, in order to ensure high market quality, the LISO waiver should work properly and be able to capture fundamental liquidity in capital markets.
LISO
Market participants’ views are here again conflicting, and include those who would reduce the threshold given that the average size of orders is
Market views
76 As part of ‘slice and dice’ defensive trading strategies in order to reduce market impact. 77 See footnote 75.
constantly dropping78 and those who fear inflating ‘dark markets’ at the benefit of a small part of the market that makes large use of this waiver, while eventually deteriorating market quality. The former group claims the importance of applying the waiver in a consistent and efficient manner. As recently estimated on the UK market (LSE Group, 2010), the difference between the standard market size (SMS)79 and the LISO thresholds is on average 44 times larger (with high volatility within the basket of most liquid stocks). In addition, from these calculations emerge that by reducing the LISO size on the FTSE 100 by 75% instead of the 25% proposed by CESR, the capacity of the value of orders that may qualify for the LISO waiver would reach almost 2% (circa 17% for the small and mid cap index). Data show how the high variability of the LIS threshold generally depends on the trading venue characteristics and size. This would suggest that deciding the LIS size by liquidity bands may be correct but the current thresholds set by each bands may not reflect the changes in the standard market size, which has been gradually going down in the last years (in particular, with the introduction of MiFID). Therefore, this part of the market is asking for a review of the LIS thresholds and a consistent reduction in order to allow lit order books (in particular, those ones using hidden orders facilities) to compete more efficiently especially with dark MTFs.
The latter group, instead, believes that current thresholds are sufficient and that a reduction would increase the size of non-displayed trading and liquidity fragmentation, ultimately hampering the price discovery process. Small investors claim that the reduction of the average size of orders has been mainly caused by trading methodologies of intermediaries, so a reduction of the LIS may only benefit them, with unclear effects on end investors. In their view, the size of small end investors’ orders has not decreased; therefore the way how intermediaries handle them should not affect in any case the way how end investors decide their investments.
CESR also discussed the treatment of residual LIS orders (so-called ‘stubs’), with no final answer but a majority of its members agreed that stubs may need to become lit to avoid distorting price formation (CESR, 2010b). In their view, this will not have the same market impact. However, other members of CESR and some market participants have highlighted that the immediate publication of stubs may reveal the original size of the large order or leak private information on the handling of these trades (especially if the execution is not completed yet), leading to stubs not being executed at all. If a stub is modified by the trader, market participants generally agree that the LIS waiver should not apply.
Stubs
The negotiated trade waiver is typically used for transactions bilaterally negotiated with other parties, so not accessible to other members on RMs and MTFs. A protection from pre-trade transparency would here enable intermediaries to provide best execution (CESR, 2010b) and give the opportunity to investors to exercise their contractual power. Applying pre- trade transparency requirements to these trades may deceive price discovery
Negoti ated trades
78 See section 5.5.
79 Orders above the SMS are typically considered as orders that may deserve a ‘special treatment’ due to their market size, also outside the official trading venues (OTC; Recital 53, MiFID).
processes since economic terms of the execution are the result of specific conditions that do not reflect current market prices. Moreover, the waiver aims at avoiding some trades destabilising displayed continuous trading systems due to their systemic importance. In Q1 2010, those trades were 3.7% of EEA trading on RMs and MTFs, with a stable trend from 2008. From an economic and financial standpoint, negotiated trades are very similar to OTC trades, as ‘upstairs trading’.80 The main difference is that an OTC trade carries best execution duties, since it is executed through a broker-dealer (execution on behalf of the client), while negotiated trades do not benefit of best execution duties since they are the result of ‘face-to-face’ or ‘back-to-back’ transactions.
There is widespread agreement that this waiver should be retained. It plays a crucial role in reducing systemic risk of OTC trades that cannot be executed on a central trading mechanism. It is also used when principal transactions (back-to-back) are not subject to current market price but to a principal Volume Weighted Average Price (VWAP; CESR, 2010b). Some market participants believe that this waiver should be extended also to RMs and MTFs that do not offer a displayed order book or continuous trading.
Market views
Turning onto the order management facility waiver, there is widespread agreement that this waiver should be kept with no major changes. It allows better management of orders kept in ‘reserves’ (e.g. iceberg orders) in order to be used whenever the market would be under stress due to several aggressive orders hitting the book at that moment. The waiver therefore allows a more efficient execution service, attracting more liquidity through brokers. CESR (2010b) clarified that differences between RMs/MTFs and brokers applying this waiver should remain, as they perform two different functions in financial markets.
Conclusion # 3
Under certain conditions, pre-trade transparency may impair market liquidity. Hence, MiFID introduced waivers, which should be retained. A move towards a more rule-based approach should be balanced with flexible application and ongoing supervision in order to meet market needs. However, conflicting views between Members emerge when discussing the breadth of these exemptions. In effect, thresholds may need to be revised regularly, in line with latest market developments. However, conflicting views between members emerge when discussing the breadth of these exemptions. More specifically, regulators need to carve out a new set of rules that promote the smooth functioning of capital markets and meet investors’ needs with no adverse impact on market structure, which may ultimately affect market liquidity, efficiency and investor confidence. Consistent and uniform application across Europe should be ensured.