How Does MiFID II Impact the Rerouting of Large-In-Scale Trades within Europe?

Concept

The implementation of the Markets in Financial Instruments Directive II (MiFID II) fundamentally re-architected the European trading landscape. A central objective of this regulatory overhaul was to enhance transparency across asset classes, a goal that directly reshaped the execution protocols for large-in-scale (LIS) trades. The directive introduced stringent volume limitations on non-lit, or dark, trading venues.

These double volume caps (DVCs) restrict the amount of trading in a particular stock that can occur in a dark pool to 4% on a single venue and 8% across all dark venues in the European Union over a 12-month period. Breaching these caps results in a six-month suspension of dark trading in that instrument.

This regulatory pressure prompted a significant rerouting of institutional order flow. Large orders, which had previously sought the anonymity of dark pools to minimize market impact, now faced a new set of constraints. The directive, however, provided a specific exemption for trades classified as large-in-scale. This LIS waiver permits block trades to execute within dark venues without contributing to the double volume cap calculations.

The immediate consequence was a pronounced migration of volume towards venues and mechanisms that could facilitate LIS-or-larger block trades. This created a bifurcated dark market ▴ one for smaller, sub-LIS orders subject to the DVCs, and another, burgeoning market for institutional-sized blocks.

The rerouting of these large trades is a direct response to the incentives embedded within MiFID II’s framework. Asset managers, driven by their best execution mandate, must find liquidity for large orders while minimizing information leakage and adverse price movements. The LIS waiver provided a sanctioned channel for this activity, leading to a surge in volumes on platforms designed to handle block trades.

This shift was not merely a passive migration; it spurred innovation in trading technology and the rise of new execution venues. Systematic Internalisers (SIs), which are investment firms that trade on their own account when executing client orders, also became a prominent destination for order flow, offering another route for bilateral liquidity provision outside of traditional lit markets.

MiFID II’s double volume caps on dark trading directly incentivized a strategic shift of large orders to venues supporting LIS-exempt block trades.

The recalibration of the LIS thresholds themselves was a critical component of this new architecture. The European Securities and Markets Authority (ESMA) adjusted the thresholds to account for the varying liquidity profiles of different stocks. For instance, the LIS threshold for stocks with an average daily volume below €100,000 was set at €15,000, while the most liquid equities required a block size of €650,000 to qualify for the waiver. This granular approach sought to maintain the viability of block trading across the spectrum of traded instruments, acknowledging that a one-size-fits-all threshold would have choked off liquidity in less-traded names.

The impact extended beyond European markets. The demand from EU clients for LIS execution pathways influenced trading behavior in other regions, as global asset managers sought consistent execution strategies across their portfolios. The directive effectively created a new equilibrium in European market structure, one where the routing of large trades is a function of a complex interplay between regulatory exemptions, technological innovation, and the enduring institutional demand for discreet, efficient execution of substantial orders. The result is a more segmented and technologically advanced ecosystem for block trading.

Strategy

In the post-MiFID II environment, the strategic imperative for institutional traders is to navigate the fragmented liquidity landscape to achieve efficient execution for large-in-scale orders. The directive’s constraints on dark trading necessitated a move away from passive reliance on traditional dark pools for all non-lit execution. A successful strategy now involves a multi-pronged approach that leverages the specific exemptions and venue types favored by the regulation. This requires a deep understanding of the available liquidity sources and the technological tools needed to access them.

The Rise of Specialized Venues

The primary strategic adaptation has been the increased utilization of platforms specifically designed for LIS block trading. Venues like Turquoise Plato Discovery, Cboe LIS, and Liquidnet experienced a significant uptick in volume as they became the designated arenas for institutional block liquidity. These platforms offer sophisticated order types and matching logic tailored to the needs of the buy-side, such as conditional orders that allow traders to rest large parent orders across multiple venues without revealing their full size until a matching opportunity is found. This technological sophistication is a key element in mitigating the information leakage risk that is inherent in large trades.

Another critical component of the new strategic framework is the use of Systematic Internalisers. SIs, typically large banks or high-frequency trading firms, provide a source of bilateral liquidity. For a buy-side firm, routing a large order to an SI can be an effective way to find a single counterparty for a block trade, thereby avoiding the need to work the order on a lit exchange and risk adverse price selection. The growth of SIs as a destination for institutional flow represents a significant structural change in the European market, moving a substantial portion of trading activity off-exchange and onto these bank-operated venues.

Effective LIS trading strategy in the MiFID II era hinges on leveraging specialized block trading venues and Systematic Internalisers to source non-lit liquidity.

How Have LIS Trading Volumes Evolved Post-MiFID II?

The data on LIS trading volumes since the implementation of MiFID II underscores the magnitude of this strategic shift. In the early days of the directive’s application, the proportion of dark trading classified as LIS grew dramatically. For example, in January 2018, LIS trades constituted about 12% of all dark market activity.

By April of the same year, that figure had climbed to 45%. This demonstrates a rapid and decisive rerouting of institutional flow in response to the new regulatory incentives.

The table below provides a conceptual illustration of how trading volumes might have shifted across different venue types for a hypothetical large-cap European stock following the implementation of MiFID II.

Algorithmic Execution and Best Execution

The fragmentation of liquidity across these different venue types has made algorithmic execution strategies more important than ever. Sophisticated algorithms are required to intelligently source liquidity across lit markets, LIS venues, and SIs. These algorithms must be able to “slice and dice” large parent orders into smaller child orders and route them to the most appropriate destination based on real-time market conditions and the specific characteristics of the order. For LIS trades, algorithms can be designed to seek out block-sized liquidity on specialized venues before interacting with the lit market, thereby minimizing market impact.

The best execution obligations under MiFID II also play a crucial role in shaping these strategies. Asset managers are required to take all sufficient steps to obtain the best possible result for their clients, taking into account factors such as price, costs, speed, and likelihood of execution. This means that the decision of where to route a large trade is a complex one that must be justified and documented. The use of advanced Transaction Cost Analysis (TCA) is essential for evaluating the effectiveness of different execution strategies and demonstrating compliance with the best execution mandate.

Execution

The execution of large-in-scale trades in the MiFID II framework is a procedurally complex undertaking that demands a sophisticated technological and operational infrastructure. The process begins with the pre-trade analysis and selection of an appropriate execution strategy. This is a departure from a simpler, pre-MiFID II world where a large institutional order might have been routed by default to a single dark pool. Now, the execution plan must consider a wider array of venues and protocols, each with its own distinct advantages and disadvantages.

A Procedural Framework for LIS Execution

An effective execution process for a LIS trade can be broken down into several distinct stages. Each stage requires careful consideration of the regulatory constraints and the available technological tools. The objective at every step is to maximize the likelihood of a successful execution while minimizing adverse selection and information leakage.

1. Pre-Trade Analysis and LIS Qualification The first step is to determine if the order qualifies for the LIS waiver. This involves checking the size of the order against the ESMA-defined LIS threshold for the specific instrument being traded. These thresholds are based on the average daily turnover (ADT) of the stock. A trading desk’s Order Management System (OMS) must have access to up-to-date LIS threshold data to make this determination accurately.
2. Venue Selection and Liquidity Seeking Once an order is confirmed as LIS-eligible, the trader must decide where to seek liquidity. This is where modern execution algorithms and Smart Order Routers (SORs) become critical. The SOR can be configured to ping multiple liquidity sources in a specific sequence. A common strategy is to first seek a block-sized match on a dedicated LIS venue or through a conditional order book. If a full or partial fill is achieved, the algorithm can then be instructed to work the remainder of the order through other channels.
3. Interaction with Systematic Internalisers Parallel to seeking liquidity on LIS venues, the execution strategy may involve sending a Request for Quote (RFQ) to one or more Systematic Internalisers. This allows the trader to access the proprietary liquidity of these firms. The RFQ process is typically automated, with the trading system managing the communication with the SIs and evaluating the quotes received. The bilateral nature of SI trading can be particularly advantageous for very large orders, as it contains the execution to a single counterparty.
4. Contingent and Conditional Orders The use of contingent or conditional orders is a key tactic for executing LIS trades. These order types allow a trader to rest a large order in a dark venue without committing to the trade until a suitable counterparty is found. This “low-touch” approach helps to avoid signaling the trader’s intentions to the broader market. When a potential match is identified, the system can then send a firm-up message to confirm the trade.
5. Post-Trade Reporting and Analysis Even though LIS trades are exempt from the pre-trade transparency requirements and the DVCs, they are still subject to post-trade reporting obligations. The reporting of the trade can be deferred, giving the institutional investor time to complete their trading program without revealing their full position to the market. Following the execution, a thorough TCA is conducted to assess the quality of the execution against various benchmarks. This analysis feeds back into the pre-trade decision-making process for future orders, creating a continuous loop of improvement.

Executing a LIS trade under MiFID II is a multi-stage process that relies on sophisticated order routing technology to navigate a fragmented liquidity landscape.

What Are the Key Data Points in LIS Threshold Calculation?

The determination of LIS thresholds is a data-intensive process managed by ESMA. The primary data point is the Average Daily Turnover (ADT) of an equity instrument. The table below outlines the LIS thresholds for different ADT bands, as established under MiFID II. This data is fundamental to the pre-trade qualification process.

The Technological Imperative

The successful execution of this strategy is contingent on having the right technology. The modern trading desk must be equipped with an Execution Management System (EMS) that can seamlessly integrate with the various liquidity sources and provide the sophisticated algorithmic trading capabilities required. Key technological components include:

• Smart Order Routers (SORs) These systems are the workhorses of modern execution, capable of dynamically routing orders to the optimal venue based on a wide range of parameters, including the LIS status of the order.
• Connectivity to LIS Venues and SIs A trading desk needs direct and reliable connectivity to the full ecosystem of LIS-enabled venues and Systematic Internalisers. This often involves managing multiple APIs and FIX protocol connections.
• Conditional Order Support The EMS must be able to support the creation and management of conditional orders, allowing traders to participate in these specialized liquidity pools without exposing their hand.
• Integrated TCA Transaction Cost Analysis tools should be integrated directly into the trading workflow, providing real-time feedback on execution quality and enabling comprehensive post-trade reviews.

The rerouting of large-in-scale trades under MiFID II is a complex process that has reshaped the European equity market. It has created a more fragmented but also a more technologically advanced environment for institutional trading. Success in this new landscape requires a deep understanding of the regulatory framework, a sophisticated execution strategy, and a robust technological infrastructure.

Reflection

The structural shifts induced by MiFID II are a testament to the market’s adaptive capacity in the face of regulatory change. The rerouting of large-in-scale trades is a prime example of this evolution, demonstrating how order flow will invariably seek the path of greatest efficiency and least market impact. The frameworks and protocols that have emerged in response to the directive’s transparency mandates are a new layer in the complex system of European market microstructure. For the institutional principal, understanding these new pathways is foundational.

The true strategic advantage, however, comes from integrating this knowledge into a holistic operational framework. The question to consider is how the architecture of your own trading and compliance systems allows you to not only navigate this new landscape but to extract a persistent edge from its complexities. The regulations have redrawn the map; the opportunity now lies in mastering the new geography.