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Every Trade Counts Ahead of Europe’s Looming Dark Pool Crackdown

Wednesday, December 21, 2016

Operators of European stock markets are finding that bigger is better.

In the New Year, regulators will be counting every European stock trade to see whether a transaction took place in a dark pool or on a public exchange -- before rules capping the percentage of dark trading begin in 2018. Crucially, special rules for larger trades could keep the dark pools open and available to investors.

With that in mind, companies such as London Stock Exchange Group Plc’s Turquoise and a venture from Bats Global Markets Inc. are trying to give clients more confidence in placing large orders.

“It will soften the blow when the caps kick in,” Neil Bond, head of trading at asset manager Ardevora, said of the new initiatives. “People are already starting to think how they’ll deal with it.”

Dark pools were given their name because they obscure bids and offers, preventing other traders from sniffing out an investor’s block orders to bet against them.

European regulators worry that dark pools, intended to hide and protect whale-sized trades, have instead become dominated by chopped up, tiny algorithmic ones. It’s a concern because the market’s shift to the dark could make prices on public exchanges less accurate.

Turquoise’s initiative has taken some time to get going since it started in 2014, but last month it executed trades worth 1.5 billion euros ($1.6 billion) at an average size of 312,099 euros. Nearly 60 percent were big enough to be exempt from the dark-pool limits.

Trading on the venue jumped after it partnered with an investor-broker consortium that includes Norway’s sovereign-wealth fund. Robert Barnes, chief executive officer at Turquoise, has said its secret was attracting those previously on the sidelines to give the venue a chance.

Starting in January 2018, each dark pool will only be able to handle 4 percent of overall trading in an individual security, while total dark trading will be restricted to 8 percent of overall volume in each stock. The calculations are based on the previous 12 months of data, which is why every dark-pool trade in 2017 will matter. Breaching the limits means the stock will be banned from trading in the dark for six months.

According to an estimate from the LSE, all 100 of the U.K.’s biggest stocks could no longer be eligible for dark pools when the limits start. A solution is to start bulking up trades now. If next year’s dark-pool orders are bigger in size, they will avoid the caps on venues and stocks being introduced under a broad revamp of European Union financial rules, known as MiFID II.

Regulators worry that markets will become less efficient if the platforms take too much trading from public exchanges like LSE and Euronext. That’s why MiFID II limits off-exchange trading.

Data suggest the market is moving in the right direction.

“All of these things will make a difference,” said Anish Puaar, a European market-structure analyst at Rosenblatt Securities Inc. “These are all little tweaks to behavior that mean there could be less impact than people expected. There’s still a long way to go, though.”

The cap rules will act as an incentive to bulk up dark pool orders, said Mark Pumfrey, CEO at Liquidnet Holdings Inc.’s European unit.

“Firms that trade in the dark will use large in scale as a target,” he said. “If you do not do that, you are in for an almighty shock.”

Investment Technology Group Inc. and Liquidnet have specialized in block trading for years. Liquidnet’s venue had an average trade size of 619,000 euros in November, while ITG’s specialized system for block trades stood at more than 900,000 euros. What the EU regards as large-in-scale ranges from 15,000 to 650,000 euros.

Handling a big trade in one swoop is generally a cheaper way to transact: breaking it into pieces and executing on the public market gives others a chance to drive prices against the investor. The problem is that it’s rare for whale orders to find each other. Most transactions are made via sliced up algorithmic trades.

“If you speak to any buy-side trader, they like to trade blocks,” said Mark Hemsley, CEO of Bats Europe. “They tend to like environments where they’re likely to bump into other buy-side flow.”

Bats, operator of the biggest pan-European exchange, launched a project for larger trades earlier this month. It partnered with BIDS Trading LP, a U.S.-based service, to get it off the ground faster. Investors will eventually be able to place orders on the system directly.

Bloomberg LP, the parent of Bloomberg News, is an investor in BIDS. Bats also started another project last year that’s meant to boost trade sizes, called periodic auctions. It executed some 333 million euros of equities in November, about triple the amount in August.

Ardevora’s Bond said he likes Turquoise’s block initiative and also uses the existing BIDS service in the U.S. “It will give Turquoise a good run for the money and some competition is healthy,” he said. “But there is not room for several similar offerings.”

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