MiFID II Double Volume Cap: Slam Dunk or Air Ball?

The recent rise of dark trading is in direct conflict with the regulators’ objective of providing greater transparency across European capital markets; hence the imposition of the Double Volume Cap (DVC) under MiFIR. However, the regulators may be looking at the probability of an air ball rather than the slam dunk for which they had hoped. The way the DVC is constructed means that overall dark volumes may not be affected, but what constitutes this volume will.

There are important exceptions to the DVC. It does not cover all types of dark trading, nor all venues. Establishing which trades will fall under the DVC and when may prove just as onerous as calculating the DVC itself. Meanwhile, market practitioners are scratching their heads to understand just how the cap will work in practice.

A harmonized calculation methodology across trading venues, including single-counted transactions, will be critical starting Jan. 3, 2017. The 4% and 8% caps are dependent on data that currently is not available, and the supposed solution of a Consolidated Tape is still far from reality. Even if the data is made available by venues today, there is little opportunity for the industry to verify this data, given that information will come from individual venue sources rather than across the industry. Time is running out fast and the danger of unwittingly breaching the caps is creating a climate of fear.

So does disaster loom? Not quite. Firms have the opportunity to avoid the Double Volume Cap provided they trade using the Large-in-Scale (LIS) or Order Management Facility (OMF) waivers, and in some instances a subset of transactions executed under the Negotiated Transaction (NT) waiver. Once again, the level of complexity surrounding order execution and the necessary data to be passed onto market participants and regulators alike via the use of the correct trade flag identifiers highlights the need for greater technology.

The vast amounts of data that firms are going to need to collect, parse, store, and make available to ensure they are compliant will be a minefield. For practitioners that owe best execution obligations to clients, this can present a marketing opportunity in terms of technology capabilities to achieve best execution; it but also can result in practical challenges, such as how many venues does an organisation wish to engage with to meet best execution obligations. New innovative models are already emerging to meet the challenges and are likely to be just the start of a new round of industry innovation.

However, the largest elephant in the room remains the ambiguity surrounding the future of Broker Crossing Networks (BCNs). The DVC only applies to transactions taking place on a trading venue, i.e. a regulated market (RM)/exchanges or a Multilateral Trading Facility (MTF). It does not apply to transactions executed outside a trading venue, such as a Systematic Internaliser (SI), or trades conducted over the counter (OTC). Clarification on the definition of the Systematic Internaliser thresholds is due in the forthcoming Delegated Acts still outstanding. However, there is growing consensus that if the firms crossing activity is systematic and material to its business as opposed to ad-hoc in nature, the chances are the forthcoming DA will tighten the definitions of SI activity to force BCNs down the multilateral route.

This raises a number of questions. If the quantity of dark trading should be reduced, imposing a system that ignores large chunks of dark activity would appear to preference one style of dark trading over another, while avoiding the need to improve the quality of dark activity. One point is certain: The imposition of the DVC will not automatically deliver a reduction in dark trading, but we may inadvertently end up with a concentration of trading activity on a reduced number of venues.

The political situation is unlikely to provide any immediate solutions. Although the European Parliament inserted a clause for the European Commission to review the DVC in March 2019, nothing will be in place by January 2017. In the meantime, the market is likely to face a myriad of order types and venues until the industry consolidates back down to the bare minimum. The question then becomes whether this will provide the necessary enhancements in best execution.

To discuss these challenges, TABB Group has broken down the various constituents of the Regulatory Technical Standards to provide a detailed look at the new obligations and what they will entail for all market participants across the globe.