13/02/18

Why MiFID's New Trading Venues Passed on Undercutting Exchanges

(Bloomberg) -- Here’s another quirk from the early days of MiFID II: algorithmic traders like Virtu Financial Inc. are deliberately opting not to use a pricing advantage.

Systematic internalizers, the new breed of lightly regulated trading venue ushered in by this year’s European regulatory overhaul, aren’t subject to MiFID’s “tick-size” regime governing the minimum increment for stock pricing. Traditional stock markets have feared this would give the venues run by Virtu and more than a dozen other companies an unfair leg up.

Yet several of the larger SIs say they are chasing major clients that don’t care about executing small-tick trades. And one person at a major algorithmic trader, who asked not to be identified, said their firm decided not to undercut the big exchanges on tick sizes because regulators have signaled that the discrepancy will eventually be eliminated.

“There’s lots of noise and excitement about it, but I see some exchanges fighting a battle that’s not likely to be taken up by SIs,” Mark Hemsley, chief executive officer of Cboe Europe, an operator of equity-trading venues, said in an interview.

Three of the algo firms said they would only use the pricing advantage if one of their bigger competitors starts doing so, forcing them to follow suit.

Tower, XTX

MiFID’s tick-size regime differs by stock. SIs quoting stocks in smaller increments than the exchanges would probably offer prices only 0.1 basis point above or below the price set out in the tick-size regime.

Virtu, the most high-profile speed trader, is concentrating on big trades rather than smaller tick sizes because that is what its fund manager clients want, a spokesman for the company said. Tower Research Capital, Citadel Securities, Sun Trading and XTX Markets Ltd. all said they have decided not to use the pricing advantage. A spokesman for Jane Street Financial Ltd., which also operates an SI, declined to comment.

None of the SIs run by algo traders or electronic market makers existed before Jan. 3, so they are currently scrambling to persuade fund managers to use their services. Major lenders, like Bank of America Corp., also operate SIs, but European exchanges accept that banks need to trade with their clients directly, as they have for decades. What they don’t accept is that algorithmic trading firms can use MiFID to do exactly the same thing.

The debate matters because MiFID II was intended to make markets fairer. Euronext NV and Deutsche Boerse AG claim that the small ticks will let SIs inappropriately siphon trading volumes away from the exchanges, resulting in less rather than more price transparency. Nasdaq Inc. and Bolsas y Mercados Espanoles are also demanding further restrictions. (This position isn’t unanimous: London Stock Exchange Group Plc is the only major stock exchange to support systematic internalizers.)

Euronext didn’t respond to a request for comment, while Deutsche Boerse declined to comment. Pressure from the exchanges has already prompted the European Union’s markets regulator to propose ending the pricing advantage, but it won’t be able to change the law for months to come.

Best Execution

The algo traders are among the exchanges’ biggest customers. Now that they can trade directly with fund managers, the algo firms can bypass the exchanges, potentially posing an existential threat to the likes of Euronext and Deutsche Boerse. SIs are far less controversial in fixed-income and derivatives markets, where fund managers are using them to escape some of the most onerous reporting requirements in MiFID II.

The banks and high-speed traders operating systematic internalizers are keen to highlight advantages other than the small tick size. They argue that the trading venues allow counterparties like fund managers to complete their trades without moving the market against themselves -- something that happens on a so-called “lit” market like a stock exchange.

They also hope that another part of MiFID -- the rules on so-called best execution -- will persuade fund managers to use SIs. Stock exchanges are often much more expensive than SIs because they charge fees for execution.

“If systematic internalizers improve execution quality for our customers, we will access them in pursuit of best execution,” Natan Tiefenbrun, head of EMEA execution services at Bank of America, said in an interview.

By one estimate, trading of European stocks on dark markets could triple under MiFID II, with SIs accounting for much of the growth in market share. Ultimately, fund managers and the brokers they use to execute their orders will determine whether SIs triumph at the exchanges’ expense.

“We are neutral -- we are trying to be Switzerland on this,” said Rob Boardman, who runs the European business of ITG, a broker and dark-pool operator that doesn’t operate an SI. “We will take you there if it’s the best execution, and we won’t if it is not.”