Competing in the dark: LSE prepares to go live with midday auction

When Brian Schwieger joined the London Stock Exchange (LSE) two and a half years ago – moving ‘just over the road’ from Bank of America Merrill Lynch, where he headed up electronic trading – the new head of equities went around asking people what they would change if they were in his position.

One of the things the buy side kept coming up with, says Schwieger, was the idea of an intra-day auction. While this mid-session pause is already in place in Germany, Schwieger described the move as ‘a very significant change to the trading day’ in a press release last year. And with good reason: when the midday auction goes live on March 21, it will be the first time in more than 200 years that trading will be halted mid-session.

But why has the LSE decided to make this move now, and what does it mean for IROs?

Dark trading has been growing in popularity among big investors for some time, while high-frequency trading (HFT) has also been increasingly in the spotlight – even more so following the publication of Michael Lewis’s Flash Boys in 2014. Trading in an auction – as is done at the start and end of the day – allows investors to avoid HFT while being able to place big blocks of trades in a way that reduces market impact.

With traders having the whole day to trade in the dark pools, however, why would they opt to wait for a two-minute break in the middle of the day? Partly because of Mifid II, that beast of recently delayed regulation now set to come into place across Europe at the start of 2018. Dark pools come under Mifid II’s wide reach and Schwieger says when the LSE realized the regulation ‘was going to put constraints around that, we recognized that the market would start looking for alternatives.’

Dark-pool double-caps

The ‘double-volume cap’ planned under the European regulation aims to limit the amount of dark-pool trading – the true extent of which is not really known – in any given stock. Dark trading in a single stock will be capped at 4 percent for a single venue and 8 percent across all venues. Any stock breaching the limit will face a six-month ban from trading in the dark and will have to move to lit venues, such as stock exchanges.

The LSE has been looking at how these caps might affect trading, explains Schwieger. ‘Based on our latest study, if we applied the rules in 2014 and the first half of 2015, the entire FTSE 100 would have been caught under the double-cap,’ he says. ‘At one point, the entire FTSE 100 would not have been able to trade in the dark pool for up to six months.’

While he concedes that there is likely to be some wiggle room when the restrictions come into place, he says ‘it became quite clear that in terms of electronic trading there was going to be a need for some kind of alternative – and that’s when we came back to the idea of the intraday auction.’

Initially the LSE had been looking at a 2.00 pm pause, to be closer to US market opening times. But the buy side is looking for more exchanges to follow the Deutsche Börse, which takes a pause at 1.00 pm UK time, says Schwieger, and ultimately ‘to have a pan-European 12.00 pm auction. It gives [the buy side] an opportunity to trade a slice, if you like, of a pan-European portfolio.’

A fairer fair price

Another difference Schwieger highlights between dark pools and an auction is the fact that while dark pools are price-referencing,‘they don’t set a price – the auction actually sets a price.’ And that’s what makes the change interesting to IROs, he says. The stock price set at the midday auction will offer a better valuation than the continuous trading ticker.

The average size of a trade on the LSE has reportedly dropped from around £20,000 ($29,000) a decade ago to between £5,000 and £7,000 today – but trades in auctions are generally much larger. ‘In an auction, you’re getting millions of pounds trading at once,’ says Schwieger. ‘Millions of pounds traded at a price of £1.85, for example, has clearly got to be a better price than £7,000 traded between two people at £1.80.

‘It’s a really true valuation – the best we can give – of the stock at that point in time.’