This blog post originally appeared on TabbFORUM.
Tabb Group’s new report, “European Equity Trading 2012/2013: Changing the Rules of Engagement,” highlights some issues that we must hope politicians will note during their review of the MiFID regulations.
It’s no exaggeration to say that Tabb’s research profiles an equity market in crisis ─ arguably one that is dysfunctional in some important respects. “Lit book” trading volumes have again fallen sharply in 2012, and there has not been a correspondingly large increase in dark pool trading. So the predicament, as it appears to most buy-side firms, is one of vanishing liquidity. And the buy-side’s primary concern – as reported to Tabb – is how and where to find what liquidity is left.
There are worrying signs of a self-reinforcing downward spiral, so one objective of regulatory change should be to stop or even reverse this trend. Good liquidity, after all, usually implies tight price spreads and the best results for end investors – the people whose interests the MiFID regulations are intended to serve.
The market fragmentation unleashed in 2007 hasn’t helped in this respect, as it has spread the thin post-crisis trading across an increasing number of platforms. In the absence of a consolidated tape of traded prices, fragmentation has also posed another challenge to the buy side: a serious lack of market transparency. This, at least, looks likely to be rectified with MiFID II.
But can MiFID II help with the liquidity crisis?
At the moment, it does not look likely. Even if we put aside the threat of a minimum resting time for orders ─ which may not appear in the final regulation ─ MiFID II has worrying implications for liquidity. A central finding in the new Tabb research is that block trading is in decline, with traders instead choosing to slice large orders via algorithms and then trade many of those small slices in dark pools. It’s clear that asset managers are increasingly finding this the safest and most efficient way of implementing buy and sell decisions in major portfolio adjustments.
But the broker crossing networks and dark multilateral trading facilities (MTFs) that support this mode of trading will not be allowed to do so after the implementation of MiFID II as it’s currently drafted – MTFs and “systematic internalisers” will have pre-trade transparency waivers only for “large in size” orders. So, who knows where those fugitive smaller orders will get executed? When we consider this factor alongside the constraints on market-making activity implied by the MiFID II drafts, it seems clear there is potential for a further downturn in liquidity.
Elsewhere in the Tabb Group report, it’s positive to see the increasing focus on execution quality and the rising usage of transaction cost analysis (TCA) in measuring it – often with multiple systems now being used for cross-checking. But the liquidity concern remains: if new regulation causes further volume reductions, then the market impact of larger orders will grow and those detailed TCA reports could make for depressing reading.
So let’s hope that MiFID’s apparent mantra of “transparency at all costs” is moderated, before the costs become too high.
