Banks' in-house trading networks under scrutiny

BRUSSELS (Reuters) - European regulators will closely scrutinise investment banks' in-house share trading networks over the next year to see whether they provide fair pricing to investors and transparent-enough data to the market.

As the European Commission's markets in financial instruments directive (MiFID) comes up for review, regulators find themselves in the middle of a slanging match between exchanges and investment banks over this issue.

So far they have sat on the fence.

The Committee of European Securities Regulators (CESR) first wants to look at the figures and analyse them, its Chairman Eddy Wymeersch told the Federation of European Securities Exchanges (FESE) Convention this week.

"If it appears there is a problem and that distortions might have a major impact on investor protection, then we will have to step in," he said.

Stock exchange officials say investment banks' "dark pools" and crossing networks, in which they bring together two sides of a trade, are functioning like multilateral trading facilities (MTFs) without being subject to the same rules on pricing and reporting of trades as exchanges and MTFs.

"The question is why are the broker crossing networks not covered by MiFID?" said Hans Ole Jochumsen, president of NASDAQ OMX Nordic. "Why should there be any difference between the treatment of exchanges versus crossing networks?"

Bankers say they are already subject to plenty of rules on market abuse, conflicts of interest and best trade execution.

"Brokers have always acted as intermediaries," said one. "What has happened is that a portion of this over-the-counter business has become more automated and more efficient."

They say exchanges have ulterior motives for lobbying against them. "The former monopolists are trying to win back in the corridors of power what they lost in the marketplace," said another banker.

BANK INCENTIVES QUESTIONED

But another critic of the banks, Richard Balarkas, president and chief executive of Instinet Europe Ltd, said they are not necessarily motivated to do the best job of searching through exchanges and other venues to get the best price for clients.

"If I am an investment bank, I am incentivised to internalise client order flow," he said, noting banks get commissions from both sides of a trade and pay nothing in exchange or MTF fees. Banks' proprietary traders also get first crack at taking the other side of an order.

"There are many reasons why the banks want to run big internal crossing engines, and they hit up against conflicts of interests," he said.

A banker countered that big buy-side clients are more than capable of making sure they get good prices and even employ specialist firms to do cost analyses after the fact.

FESE officials estimate about 40 percent of European share trading is now over-the-counter (OTC), with banks accounting for the lion's share. There is no pre-trade transparency in this huge chunk of the equity market, and so it does not contribute to price discovery, exchange officials say.

The London Stock Exchange's share of trading in British stocks was 57.7 percent in November by typical measurements, but if all types of trading including OTC are included, it drops to 44.6 percent, Thomson Reuters data show.

Even when exchanges get a waiver to operate a dark pool, MiFID rules require them to report trades right after they are executed and set prices at the mid-point between bid and ask at that moment, said Christian Katz, SIX Swiss Exchange chief.

In a dark pool, would-be buyers and sellers of large orders do not have to reveal pre-trade information, so they do not risk signalling their intentions to the rest of the market.

DIFFERENT FOR DEALERS

On the other side, a banker said:, "The FESE figures are really a long way from reality and bordering on irresponsible."

Banks' dark pools and crossing networks account for barely more than 1 percent, another banker said, citing figures from a recent TABB consultancy report.

For the bulk of the OTC market, banks are acting as dealers and doing principal trading, using their own money or share inventories to take one or another side of trades, he added.

Under existing rules, dealers are allowed up to several days to report a trade, depending on its size, because of banks' concerns they do not want to tip their hand to rivals. "The bigger it is, the later you print," said one.

If a client has a big order, he or she can ask the bank to act as a broker and search multiple venues for the best price.

The client who chooses to transact with a dealer takes responsibility for ensuring a good price versus what can be seen on exchanges, the banker said. "This is between assenting adults in private."

(Additional reporting by Huw Jones; Editing by David Holmes)