An overview of the European dark pools regulatory landscape

While the progression of dark pools has been intensive in North America, the rhythm in Europe has been much slower (see below). So far, the percentage of dark pool trading is well below the amount of trading in North America. According to Reuters, the current market share of dark pools across European trade venues is around 6 percent. [1]

North American brokers would not have been able to bring the dark pool model into Europe without the Market in Financial Instruments Directive (MiFID) that took effect in November 2007.  

Because transparency is crucial to the proper functioning of financial markets, MiFID created rules for full transparency in equity markets, while recognizing the need to offer flexibility for certain transactions to avoid negatively affecting investors. The directive granted four different waivers, including the Large In Scale Waiver (LIS) and the Reference Price Waiver (RPW). Although only the latter waiver was created by MiFID, both aimed to exempt transactions from pre-trade transparency in case of larger orders or when the price is agreed to at the mid-point of a widely published reference price.

These waivers allowed the creation of dark liquidity pools not only by a multilateral trading facility (MTF) or regulated markets but also on broker crossing networks (BCN). BCNs are currently regulated under MiFID as over-the-counter (OTC) trading since they only perform the matching of orders without having to publish any orders to the market.

All these dark pools, by using the mid-point RPW, allow investors to trade blocks of securities while minimizing market impact, providing the benefits of anonymity and non-display of orders to their members or clients.

With the review of MiFID, dark pools are under the spotlight. In its proposal, the European Commission suggested reviewing the different pre-trade transparency waivers. Whereas the commission considered that the LIS waiver is necessary to protect the market from moving downward by publishing large orders to the public, it believed that the RPW waiver should be withdrawn. As a result, all trades that could be sent previously to dark pools now will have to be sent to a “lit” venue to facilitate price formation, representing the general idea of the new regulation. The European Parliament adopted a different position in its submitted proposal in October 2012, which clearly excluded the RPW. 

The position of the Council of the European Union is still undetermined. After suggesting that a threshold should exist, the Presidency of the Council of the European Union, currently held by Ireland, eventually proposed on April 21, 2013, as a compromise, that an 8 percent volume cap per equity on the overall business can be executed under the RPW. 

This compromise position is very similar to one offered on the other side of the Atlantic, where the U.S. Securities and Exchange Commission (SEC) has chosen to limit the growth of dark pools with a mechanism that requires that dark pool trades over 5 percent of the stock’s average daily volume amount must display bids and offers for a specific time period. 

But non-displayed MTFs are not the only dark liquidity pools currently under the spotlight. BCNs are also going to be reviewed by MiFID II. Indeed, legislators want BCNs to be captured by one of the existing MTFs or by a systematic internalizer, given that it is very likely that the new Organized Trading Facility (OTF) will not be allowed to trade equities. The European Parliament already clearly banned equities from the OTF category, but the Council of the Presidency recently reversed his position by putting back the OTF for equities on the condition that trades are not matched with the capital of the broker.  This ruling was well received by the buy-side firms because it still allows them the ability to trade in a discretionary manner. 

We can imagine that in the trialogue discussions[2] likely starting in June, dark pools will be one of the hot topics, and it is difficult to predict what the end result will be. Buy-side firms likely will observe the trialogue carefully and hope that any final rulings will protect European equity investors.

What direction do you think European regulations will take regarding dark pools? Join the discussion.

Capco's David Gest and Thomas Riesack contributed to this piece.

[1] Information calculated using the monthly market share reports from Reuters for March 2013 for all European equities turnover. It represents the market share of the total turnover of dark order book from the total order book on lit markets for all European equities. http://thomsonreuters.com/products_services/financial/financial_products/a-z/market_share_reports/#tab1 

[2] Legislative institutions that constitute the trialogue: the European Commission, the European Parliament and the Presidency of the Council of the European Union (currently, the position is held by Ireland).