CESR to Dark Liquidity: It’s On!

We all knew it would only be a matter of time before European regulators weighed in on the subject of dark liquidity pools. Over the past 18 months, these pools seem to have popped up like mushrooms and taken on the role that systematic internalizers were to play under the Markets in Financial Instruments Directive (MiFID).

Earlier this month, the Committee of European Securities Regulators (CESR) released a discussion paper to industry stakeholders in order to provide recommendations to the European Commission (EC) for the next iteration of MiFID.

Among CESR’s recommendations is the development of a consolidated tape for the European Economic Area (EEA). It also makes a number of recommendations that will gut much of the usefulness of dark liquidity.

CESR suggests that the EC establish bespoke requirements for firms operating broker crossing systems (BCSs) to register them as MTFs once the level of client business transacted on them surpasses a certain level. Not to get caught in a hornet's nest, CESR wisely suggests that the EC should determine that specific transaction level.

While this would limit the volume of liquidity traded away from the registered markets and MTFs, CESR is also suggesting a number of steps that would remove the "dark" from dark liquidity.

CESR suggests having BCS operators provide a description of their platform, including details on access to the system, the orders that may be matched on it, the platform's trading methodology and the arrangement the operators have made of post-trade processing and trade publication.

It would also like to see firms identify in their transaction reports to their competent authorities which of their transactions were executed on their BCS platforms.

With such data available, it will be somewhat easy for trading firms to reverse engineer the liquidity found on these platforms and defeat the complete concept of dark liquidity.

What is truly amazing is the volume of transactions occurring on these platforms, according to CESR's own numbers. In its research, CESR collected data from 11 European investment firms on the amount of volume transacted on these systems from the first quarter of 2008 to the first quarter of 2010; it found that the percentage of trading on these systems grew from 0.6 percent to an amazing 1.5 percent. It more than doubled, but at such low percentages, that is not a major accomplishment.

Unless the industry can demonstrate the benefits of dark liquidity to the individual investor and to the overall health of the market, it looks like it might go the way of the dodo.