MiFID II: A First Empirical Evaluation of its Effects on Equity Markets

Topic & Objectives

Dark pools – venues that provide no pre-trade transparency –  are routinely used by investors, especially large buy-side institutions, to manage order exposure costs. These venues are highly controversial due to three main concerns: (i) a lack of level playing field vis-a-vis public markets, (ii) inadequate disclosures concerning order routing decisions,and (iii) a potential to impair public markets' price discovery mechanism. Most theoretical and empirical literature explores a dichotomy of lit markets versus dark pools or transparent versus non-transparent trading. This dichotomy however oftentimes is an oversimplification of the reality of today's complex market landscape, which instead involves a wide spectrum of pre-trade transparency or “shades of grey”. This complex trading landscape raises several important questions: What happens when restrictions or limits are placed on only one form of dark trading? Does dark volume migrate to other quasi-dark mechanisms? If so, what does the volume migration reveal about which trading mechanisms are viewed as the closest substitutes to dark pool trading? Do volume spillovers to quasi-dark venues mitigate the effects of dark trading regulation? What are the effects of such regulations on market quality? And should transparency policies be broader and take into consideration the spectrum of quasi-dark alternatives? We shed light on these questions using a quasi-natural experiment provided by the European Commission's (EC) Markets in Financial Instruments Directive (MiFID II). The new regulation imposes a complete ban on trades below a size threshold in dark pools for stocks that historically traded more than 8 percent of their volume in such venues.

Key Findings

• We show that quasi-dark trading venues, i.e., markets with somewhat non-transparent trading mechanisms, are important parts of modern equity market structure alongside lit markets and dark pools.
• We find that dark pool bans lead to (i) volume spillovers into quasi-dark trading mechanisms including periodic auctions and order internalization systems; (ii) little volume returning to transparent public markets; and consequently, (iii) a negligible impact on market liquidity and short-term price efficiency.
• Quasi-dark markets serve as close substitutes for dark pools and consequently mitigate the effectiveness of dark pool regulation.

Policy Implications

• Our analysis sheds light on the extent to which the restrictions were successful in achieving the regulator's dual objective of shifting trading towards lit venues and improving the efficiency of stock prices.
• Our results highlight that in a market with several shades of dark venues (pre-trade transparency), restricting trading in one dark market mostly shifts investors to other close, albeit imperfect, substitutes.
• These shifts can have unintended consequences contrary to regulatory expectations.