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MiFID II: A War on ‘Dark Data’

 5 min read / 

The European Securities and Markets Authority is going to war with dark data (the data produced from dark trading), and its weapon of choice is ‘systematic internalisers’.

Yet, its own weapon could be changing sides.

January 3rd of 2018 marked a revolutionary day in the European securities market with the introduction of MiFID II. The original Markets in Financial Instruments Directive has been updated to cement a more transparent trading environment that also helps protect investors against market abuse. The ESMA has been under pressure for some time to find a solution to ‘dark’ trading and the lightly regulated OTC markets.

‘Dark’ trading involves transactions being totally concealed, whereby the buyer and sellers intentions are hidden from the market. This is in stark contrast to an order book system on an exchange, which has a high amount of pre and post-trade transparency. OTC markets are also used to keep larger trades less exposed to market movements, as regulation is light and the trading arena notoriously opaque.

The solutions behind MiFID II are to introduce caps on ‘dark activity’ and give investment firms more flexibility in pricing to attract trading activity that was previously in the ‘dark’ markets. The main rule will simulate an 8% trading cap on any one given stock in a 12 month period. The likely post-trading environment is summed up in a study by Rosenblatt Securities last year. The study revealed that 89% of stocks in the top 350 companies in the UK will be prone to exceeding the cap and thus be banned from ‘dark’ trading.

The liquidity will thus need a home, which the ESMA created (intentionally or unintentionally) by virtue of ‘systematic internalisers’.

An investment firm that puts up their own capital to fill client orders away from exchanges must now register as systematic internalisers. The structural shift is a move away from the unpopular broker-crossing networks. These networks come under the umbrella of OTC trading, as they match buy and sell orders without being directed electronically to an exchange first. Thus, they act like a stock market in themselves – just without much regulation.

In theory, the companies registered as SIs will have to redistribute an abundance of data on their trades, which includes pre and post-trade material. They will also have similar characteristics as official exchanges, hence making them competitors and likely taking some trading traffic away from the exchanges. This could potentially be counter-intuitive as the main goal of MiFID II is to move more trading to ‘lit’ public exchanges.

However, where there are losers, there are also winners and systematic internalisers look ready to fit that bill.

One of the main advantages SIs will have over public exchanges is the ability to price securities in smaller increments. For example, if an exchange quotes a stock at £5.00, an SI might be able to quote it at £4.999. Even though it is a small difference, a large liquid trade could give it more significance. This is likely to give SIs a competitive edge over public exchanges, whilst some critics also argue that larger volumes will be seen in dark pools.

According to the co-chief executive officer of XTC Markets Ltd, Alex Gerko, “The share of dark trading will initially go down. From that low, every month you will see maybe a 1, 2 percent uptick until it reaches somewhere like 30 percent in SIs.”

Banks such as Goldman Sachs Group, JPMorgan Chase and Co and HSBC have all registered as systematic internalisers, which means a probable scenario will see these banks (amongst others) benefitting from the first re-directed trading traffic.

Yet, MiFID II’s future inside the British Isles is uncertain at the best. The United Kingdom’s decision to break from its responsibility to adhere to EU law could see a considerable volume of work and funds to implement the new system, undone. A report by Expand, a Boston Consulting Group company, estimated that preparations for MiFID II are to have cost firms $2.1bn in 2017, with also a similar cost predicted if the system was to be disarmed later on.

A statement released by the Financial Conduct Authority last year made it clear that firms should carry on with usual implementation, as long as a withdrawal agreement from the EU is not made before the start date of 3rd January 2018.

Thus, MiFID II should apply to the British Isles until the UK formally withdraws from the EU. However, it is possible the MiFID II regime stays largely intact after the withdrawal date as parliament is likely to favour a more transparent landscape in the securities market that it offers.


The consensus from the financial sector is that MiFID II is a step in the right direction. Yet, public exchanges, for whom the new rules were meant to benefit, are now crying foul at how the new structural blueprint gives systemic internalisers an unreasonable competitive edge.

Exchanges acted as the torchbearers of change, yet it is their business model that could come under threat from the fire they lit. It will take time before one can truly distinguish whether the new system is a success. However, assuming trading traffic flows in favour of SIs and not public exchanges, the transparent and competitive market that is so desired could remain a distant dream.

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