MiFID II, Part III: Giving the Game Away, Pre-trade Transparency

Strategic impact

A centisecond is a hundredth of a second, a millisecond is a thousandth, and a microsecond a millionth. In the world where the difference between trading profit and loss is getting down to the millisecond, if timely access to information is king, it will be the king of kings in future; and MiFID IIs provisions on pre-trade transparency look set to expedite this movement. Financial professionals and algorithms do almost half their equity trading in non-transparent, or dark pools as opposed to in arrangements where there is price and volume transparency. The amount of large block trading has been rising some say ten-fold, giving rise to expected concessions on disclosures given the scale and potential resultant market movement. There are clearly pro’s and con’s with transparency; with it, people are reluctant over profitability, and without it regulators and investors are unsure whether they are getting a good deal and there is order in the markets. MiFID II is proposing some serious changes to information availability, and many are arguing that this will be market changing. Indeed firms are already beginning to align themselves favourably to prepare for this change on 3 January 2018. Given the strategic significance of the topic of pre-trade transparency, it may be fitting to take a step back and consider in the midst of all the regulatory updates, technical standards and national interpretations, where ESMA is really proposing to lead the industry and what professionals and institutions should be considering now, in the medium term, and ultimately where the industry is headed.

Let us begin with the analogy of concert tickets; they can be bought from official distributors, akin to the box office or stock exchanges for securities or listed instruments, or can be bought on the black market, akin to trading dark pools. Bringing trades into the light has been the theme of the regulatory change over the past decade, and MiFID II is proposing on building on this. Shedding light not only post-trade, but pre-trade, thereby making prospective buyers aware of what they should be bargaining for, is one of MiFID IIs goals. MiFID II will prompt players to step up their transparency game by mandating the use of venues already specified in MiFID I i.e. Regulated Markets (exchanges), Multilateral Trading Platforms (publically accessible trading platforms that have open prices leading to contracts), Systematic Internalisers (using own company inventory to address client orders – broker crossing networks), or MiFID II’s newly introduced non-equities Organised Trading Facilities (same as MTF but pertaining to non-equity trading). There are a four waivers available. Large in Size (LIS) trades will be exempt for example, and some national regulators such as the FCA have demonstrated their commitment to help ensure market liquidity by being supportive in discussions for waiver applications by participants. For investment institutions, and clients – what they choose to operate, where they envisage liquidity being, how they will consume, use and act quickly on data, are all questions almost every facet of the organisation should be asking.

An Unholy Welcome: dodging the bullet

Trading venues cited above will be required to provide a pre-trade information including venue, volume, price near real-time to the market; with RMs, MTFs, and OTFs having the more complete set of disclosure requirements. SIs will be given more leeway regarding rules on minimum quotes and trading increments (tick sizes), trade reporting is also more relaxed for SIs. As far as the regimes objective, it is like telling everybody who has anything to do with the concert tickets, including the staff at the box office, what price you are getting your black market tickets for, and thereby luring others in the box office queue to go to the same source. It is expected to open up the market like never seen before. This makes the SI regime a little more attractive, and in a market where every little helps, players are flocking to register with ESMA as an SI for particular stocks, including Morgan Stanley, Credit Suisse, and a host of smaller banks also.

Nasdaq has been trialing a service called auction on demand that will attempt to, in a MIFID II compliant manner, withhold information for as long as possible. In such arrangement, prices are put forward, and only when connected or accepted, the price and volume are made public – the trade would take a maximum of 100 milliseconds. Many such innovations are expected to follow.

The big questions

For quotes to have actionable meaning, there has to be a benchmark. In the absence of a benchmark, there must be meta data i.e. who was quote given to, and in what circumstances? Quotes will vary depending on credit risk, and size and frequency of orders? How will publication authorities disseminate all quotes in real time? For quotes to have meaning there has to be some kind of consolidation of quotes for a particular stock, who will provide this overarching view? Another term for live, or executable quotes is wire quotes – how long will they need to be live for if they go out in real time?

Being regarded as impractical for there to be one publication authority given the disparate nature of products, systems and trading geographies, this has been delegated to a number of bodies, coordination among which may or may not be necessary if the benefits of transparency are to be truly realised. A lot of this hinges on the use of regulatory technology on an industry-wide level, involving the infrastructure providers. They indeed are stepping up, however to coordinate it among so many players, is an objective with a number of years associated with it, not months.

As the strategic positioning continues, and will pick pace in the final 6 months, technological consensus and enablement will be key. Regulators’ use of this will help bring clarity on what the purpose of the regulation is, and the consolidation of a lot of data that is proposed to be collected in the vast range of regulations in the pipeline for 2018-19. As far as tactical approaches are concerned, these are most realistic, however the possibility of some investment firms being more advanced on their offerings and enablement of using venues intelligently and benefiting from some significant first-mover advantages should not be ruled out.