On 7 March 2018, ESMA published trading volumes and calculations relating to the Double Volume Cap (DVC) under the second Markets in Financial Instruments Directive (2014/65) (MiFID II) and Markets in Financial Instruments Regulation (Regulation 600/2014) (MiFIR)).
One of the objectives of MiFID II is to protect the integrity of the price formation process by limiting the amount of trading which occurs in ‘dark pools’. Dark pools are private trading venues where prices are disclosed only after a trade has been completed. This contrasts with exchanges and other ‘lit’ trading venues where deal information must be displayed before a trade is executed. The absence of so-called ‘pre-trade transparency’ has made dark pools attractive to fund managers who are reluctant to trade large blocks via a public exchange, as this can alert other investors of their intentions and push prices against them. The limited ability of regulators to monitor trading in the dark however has led to concerns that traders are not being provided best execution and that dark pool operators may have conflicts of interest and/or inadequate systems and controls.
Double Volume Cap
The DVC mechanism was introduced by Article 5 of MiFIR. It limits trading under waivers from pre-trade transparency set out in Article 4(1)(a) and Article 4(1)(b)(i) of MiFIR by imposing two caps on trading in the dark.
The first cap is reached when the percentage of trading in an instrument on a single trading venue under the waivers exceeds 4% of the total volume of trading in that instrument on all EU trading venues over the preceding year. This means that only 4% of an instrument (like a particular share) can be traded in any dark pool over 12 months. The second cap is reached when the volume of trading in an instrument on all trading venues under the waivers crosses the 8% threshold of the total volume of trading across all EU trading venues over the previous year. This means that only 8% of the total volume can be traded across all dark pools. Approximately three quarters of European stocks are affected by the DVC. In order for the DVC to come into force, market participants need this EU trading data for the calculations.
The DVC was originally set to come into force with MiFID II on 3 January 2018. The European Securities and Markets Authority (ESMA) announced that the DVC would be delayed as ESMA had not received the complete data from the trading venues in time. In the press release accompanying the publication of trading data and calculations, ESMA noted that it has worked with the National Competent Authorities and trading venues to resolve data completeness issues. As a result, ESMA published in March 2018 the DVC calculations for 18,644 instruments for January 2018 and 14,158 instruments for February 2018.
According to this data, the trading in 744 instruments for January 2018 and 643 instruments for February 2018 will be limited by the DVC. National Competent Authorities had two days to suspend the use of waivers in relation to those financial instruments. ESMA intends to publish the DVC data for March 2018 on 9 April 2018.
The success of the MiFID II’s attempts to curb dark execution is questionable. Whilst reported trading through dark pools has declined as a result of the DVCs, trading flows are not necessarily moving onto lit exchanges. Instead trading flows may be executed on ‘semi-dark’ venues. For example,
periodic auctions are not required to be made public until they reach certain volume thresholds. Whilst these auctions are technically posted on the exchange, they are often agreed before being posted on the lit market. Such auctions accounted for 0.3 per cent of all trading before the DVC. Now they account for 0.6 per cent.
Another factor that may challenge the DVC is Brexit. Switzerland, for example, does not have caps on dark trading due to its equivalence deal with the EU. Its market trading data however is included in the DVC calculations. The UK may seek to also engage in a similar position given the dominant size of its markets. Any deal between the UK and the EU that results in the UK market trading data being removed from DVC calculations, may cause European policy-makers to rethink the operation of the DVC considering just over half of all European order execution occurs through UK markets.
Alternatively the UK may not seek equivalence in this area of market structure due to the purportedly disproportionate impact MiFID II has on UK markets, including dark execution venues. Following a comprehensive 2016 review into reference prices in dark pools, the Financial Conduct Authority expressed a view that dark pools provide a valuable service to market participants and, in most cases, assisted in the price improvement process.