End ‘senseless’ ban on midpoint trading, asset managers urge

Investors decry European rule that forces them to trade some equities in whole tick sizes


Midpoint should be a valid execution price and investors permitted to trade at a half tick in Europe on all venues, say buy-side firms in fresh calls for regulators in the UK and EU27 to re-examine the tick size regime.

Trading heads also criticised the existing rule as counterintuitive and harmful in forcing them to trade at either the bid price or offer price if the spread is a single tick. The regime applies to equity trades under a set threshold.

“The tick size regime precluding the ability to execute on a sub-tick basis is one of those things that doesn’t make sense to me,” says David Stevenson, deputy head of dealing at Aegon Asset Management.

Preventing investors from trading at the midpoint means either the buyer or seller loses out, says Adam Conn, head of trading at UK-based Baillie Gifford, which manages $370 billion in assets.

“Midpoint crossing is not only effective in minimising market impact, it is egalitarian for both the buyer and the seller and any attempt to limit it is missing the objective of what the market wants and needs,” Conn adds.

A spokesperson for BlackRock, the world’s largest asset manager, says the tick size regime should not interfere with an investor’s ability to execute at midpoint even when this is a half tick. The spokesperson adds that any future changes to the Mifid regime should allow midpoint executions to take place across all venues.

Limitations on midpoint trading stem from the tick size regime baked into the European Union’s Mifid II reform of financial markets introduced in January 2018. The regime sets minimum increments that prices of equity and equity-like instruments can move.

The rule aims to stop traders undercutting each other with minuscule differences in bid or offer prices. It is also designed to guard against a race to the bottom from competing exchanges in providing ever decreasing tick sizes. Authorities believe such actions would adversely affect price formation and hurt end-investors.

Originally targeting displayed order books, the rule was extended last June to dealers’ own internal matching engines, known as systematic internalisers. This revision of the rule was, in part, a response to concerns that investors were swerving the original tick size requirements by channelling trades through systematic internalisers and away from exchanges.

Alex Jenkins
Alex Jenkins, Polar Capital

Alex Jenkins, head of dealing at boutique investor Polar Capital, believes the ban on sub-tick execution adds an unnecessary layer of complexity. “Anything that makes markets more complex is probably not something that we should continue with,” she says.

Jenkins says one way the industry has found to circumvent the rule is by dividing orders into smaller chunks. Where one-tick spreads exist, an investor might fill half the trade at one tick and the other half at the other tick in order to achieve the same average price.

But such workarounds are an imperfect solution, according to Baillie Gifford’s Conn. He believes breaking up an order raises the risk of information leakage.

“If an order has to be traded piecemeal through any lit exchange, you signal your intention to the market resulting in potentially higher market impact and lower execution performance, which is not in any of our clients’ best interests,” he says.

Despite the buy side’s criticism of the rule, asset managers often benefit from affected trades. Many systematic internalisers are programmed to trade in favour of the client if the midpoint is not at the exact middle, explains Michael Horan, head of trading at Pershing.

Size is everything

Under the tick size regime, trades above a given threshold are permitted to take place at half a tick, while trades below the threshold and other non-price forming trades cannot. The so-called large-in-scale threshold is on a sliding scale that increases with average daily trading volumes of the equity security, to an upper limit of €650,000.

The European Union’s markets regulator has also clarified that periodic auction trading systems must follow the tick size regime.

Sean Barwick, associate director at the Association for Financial Markets in Europe, which represents the region’s largest dealers, believes all trades should be able to take place at midpoint, regardless of size.

“The restriction on execution at midpoint below large-in-scale still doesn’t seem to make much sense. We think, for any size of order, you should be able to execute at midpoint, whether it’s on a trading venue or on a systematic internaliser,” he says.

Barwick adds that it is undesirable for trading venues or systematic internalisers to have to execute at a whole tick size as this will require venues to round midpoint orders up or down to the nearest tick to the disadvantage of either buyer or seller. That risks arbitrarily penalising one investor over another where both parties would be satisfied by a midpoint execution.

In a December 16 supervisory statement, the UK’s Financial Conduct Authority said it will continue applying the current tick size regime, and it clarified rules for cases in which tick sizes might vary because of differences in how EU and UK authorities calculate them. If the average daily number of trades for an EU share is higher in the EU than in the UK, the FCA will apply the tick size calculated by the EU regulator.

The UK’s markets regulator also said in the December 16 statement that it will be “keeping the tick size regime under close review”.

Some speculate that the UK could diverge from the tick size regime as it considers its future financial regulatory relationship with the bloc of 27 nations.

The European Union does not intend to amend the rule in the short term, insiders suggest. Sources close to the European Commission say the issue of midpoint matching has already been addressed as part of the recent review of investment firm regulation and there are no plans to tackle the issue further at this stage.

The tick size regime precluding the ability to execute on a sub-tick basis is one of those things that doesn’t make sense to me

David Stevenson, Aegon Asset Management

Raza Naeem, counsel at law firm Linklaters, calls the rule “painful”. He says that while the FCA has already been slightly more flexible in practice in how it is applied, other financial regulators such as Germany’s Bafin appear to have applied the rule more strictly.

“I suspect the FCA will probably try and move away from this, or try and come up with something perhaps a little more sensible or proportionate, for example by having exceptions,” Naeem says. “So, effectively, you would be able to cross at midpoint tick for best-execution purposes for clients.”

The EU27 would then increasingly become an outlier on the issue as jurisdictions across America and Asia do not apply similar regimes.

Naeem adds that brokers have set up European systematic internalisers alongside UK systematic internalisers, which trade the same types of securities. Generally, brokers would like to be able to publish the same single stream of prices across both systematic internalisers. That means if the UK dropped the tick size regime altogether, brokers – while they would welcome any reforms from the FCA that would enable them to execute off-tick – may end up complying with the EU rule anyway to make sure they have consistency.

For others, the jury is still out on the pros and cons of the regime. Paul Squires, regional head of trading at Invesco, agrees that constraining trading at midprice is “counterintuitive”, but says it may have disincentivised predatory practices by some electronic liquidity providers. Among such practices, opportunistic traders can pay an economically insignificant amount to trade ahead of other investors.

In an example from a 2012 paper by a UK government agency, a large institution might display an order to buy a security at 10.00. A trader responds by buying the same security at 10.000001. If the price rises as anticipated, the trader can make a quick profit. If not, the trader can sell to the institution for a minimal loss. The paper describes this as a “parasitic” strategy.

In February 2019, the French regulator published a paper that found the tick size regime had led to an increase in market depth around a smaller number of pricing points. Yet, there was a “slight widening” in spreads for most liquid securities. The study also claimed to observe an increase in effective transaction costs for high-frequency traders, and a reduction in transaction costs for “non-aggressive” market participants.

Exchanges, meanwhile, have differing views of the tick size rules. A spokesperson for the London Stock Exchange repeats the group’s position that investors should be allowed to execute at half tick, where it represents the midpoint, on all venues and platforms. This would allow for a level playing field and ensure no party is disadvantaged where trades are clamped to a full tick.

David Howson, president at Cboe Europe, agrees that the midpoint should be a valid execution price for all order sizes, irrespective of venue type.

“It is accepted globally as a fair execution price and is extremely beneficial to investors by reducing the spread cost,” he says. “European markets, and their investors, would be materially harmed should the ability to execute at the midpoint be constrained,” he says.

Deutsche Boerse notes that for large orders, execution at midpoint is generally allowed without tick size restrictions. But a spokesperson says that for smaller orders the “tick size regime should apply for all execution venues in the interest of a level playing field”.

A spokesperson for Euronext says: “In our view, there should be an equal playing field for all market participants whatever the rule is.”

Editing by Alex Krohn

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