Media Room

Swiss dark pool loophole an intriguing signal on post-Brexit regulation

Monday, May 09, 2016

It seems exchanges, trading firms and investors based in Switzerland may still get access to the European Union even though one key provision in its recently enacted legislation – relating to caps on dark pools – is significantly looser than its EU equivalent.

The caps on dark pool trading will come into force in the EU as part of the rewrite of the continent’s trading rulebook known as Mifid II. Even though Switzerland has closely aligned itself to EU regulation, its recently adopted Financial Market Infrastructure Act – often called FinfraG and which has only been translated into French and German – omits the caps entirely.

The omission offers an intriguing insight into life if the UK became free of Brussels’ control in the event of a vote to leave the EU on June 23, as the caps are likely to be high on the list of rules that London-based traders would like scrapped.

Anish Puaar, a European market structure analyst at Rosenblatt Securities, said: “If the UK decides to leave the European Union, then there will be questions among the financial community​ on whether the Financial Conduct Authority could theoretically change the UK's implementation of Mifid II."

It has been widely accepted throughout the Brexit debate that if London-based firms are to retain access to Europe, then the UK’s regulator will not be able to set rules weaker than those in Paris or Frankfurt. But Switzerland may have pulled this feat off.

As well as its implications for a post-Brexit UK, the gap between the two regulatory regimes could have wide-ranging implications for Swiss-based dark pools and EU-based dark pools that trade Swiss stocks – including venues operated by Bats Europe, Turquoise and brokers such as UBS, Goldman Sachs and ITG.

One European broker, which operates a large dark pool, said it was following the issue "closely, and with interest".

Dark pools display details of transactions only once they execute, and were originally designed to allow institutions to move in and out of large stock positions without revealing their intentions to others. But EU regulators fear the growth of the venues – which account for around 12% of trading in Europe – has come at a cost, and harms the price formation process on public exchanges.

In a highly controversial and politically charged move, it was decided under Mifid II to allow only 4% of an EU stock’s trading activity to take place on a single dark pool, and to allow only 8% to be traded across all dark pools.

The rules look set to disproportionally affect the UK, where a greater amount of trading takes place in dark pools than in other EU countries. A senior official at the FCA in October 2014 even described them as a ‘clunky’ approach to bring about more transparency in share trading. There are fears that buyside firms might decide to not trade rather than be forced to trade on 'lit' markets and reveal their positions to others.

In Switzerland, FinfraG became law on January 1, though it is still being phased in. Even though its final implementing standards could change it does not include dark pool caps for now, partly because the venues are not as big as in the EU, according to Ian Cornwall, head of market structure at the Six Swiss Exchange, the country's national bourse which is owned by Six Group.

Cornwall said: “The reason the dark pool caps were proposed in the EU was to add transparency and to protect price formation. The starting point for Switzerland was different in that we didn’t suffer from the same problem. Six Swiss exchange accounts for the vast majority of trading domestically and all trades have to be reported anyway.”

The impact of the difference in the two regulatory regimes will be determined by Mifid II’s ‘third country regime’, which dictates the way non-EU firms can access the EU, and to the way EU firms operate in foreign jurisdictions. Firms from a third country will only be able to provide services directly in the EU if the firm’s home country is deemed to have equivalent rules and supervision.

In the same way that Six Group’s clearing house required 'third country' approval to provides its services to EU customers under the European Market Infrastructure Regulation, the same will apply to how the Six Swiss Exchange operates under Mifid II.

The EU could force FinfraG to include dark pool caps as a condition of this equivalence decision, but market practitioners think that fairly unlikely given it is a small part of the overall reform package. The European Commission declined to comment.

The result is that dark pools based in Switzerland could operate free of the 4% and 8% caps – for Swiss stocks, at the least.

Cornwall said: “The absence of caps in Switzerland is a result of a different starting point but does not mean a lack of oversight. It is a different approach to the one envisaged in the EU which equally allows investors freedom to trade in their best interests.”

That would leave EU-based dark pools that currently trade Swiss stocks at a disadvantage, as their activity would still be capped. One obvious remedy is for these operators to re-domicile at least some of their activities in Switzerland. However, many practitioners said this would involve significant administrative upheaval, such as creating new legal documents for clients.

One European broker said: "Do I think there will be an element of regulatory arbitrage from the rules? No. Not only would it involve re-papering clients but it would also arguably go against the spirit of the rules".

There are further concerns for EU-based dark pools that trade Swiss stocks.

Many dark pools operate under a so-called reference price waiver, whereby they do not have to publish details of transactions provided the price is determined from another system such as a primary exchange. Mifid II's current drafting states that dark pools must use a reference market that is based in the EU, preventing venues from using the Swiss exchange as the reference price in Swiss stocks. Instead, they would be required to reference the second-most active market in a Swiss stock, most likely Turquoise or Bats Europe, which account for around 20% of trading in Swiss stocks.

Puaar said: “If you have to base a dark pool trade on a price which ​is ​only reflective of a fifth of the trades in a stock, ​it may not be viewed as reliable as the main market.”

These issues raise the broader question of the extra-territorial impact of Mifid. In itself, the absence of caps in Switzerland is a relatively small issue: around 9% of trading in Swiss stocks in the Swiss Market Index takes place in dark pools. But there are other non-EU securities that can be traded on EU trading venues, including US and Asian securities. Under Mifid II, EU firms would be able to trade in these instruments only after an equivalence assessment was made in respect of those non-EU countries.

Link To Article

more news »