2017 could be the year of US domination of institutional FX and equities dark pools as MiFID rules take dislike to anonymity

As if today’s liquidity market is not complicated enough, there now is a growing dichotomy between how the use of private forums for trading securities are used by large institutions on either side of the Atlantic.

The bulk of dark pool trades represent large trades by financial institutions that are offered away from public exchanges like the New York Stock Exchange and the NASDAQ, so that such trades remain confidential and outside the purview of the general investing public.

The fragmentation of financial trading venues and electronic trading has allowed dark pools to be created, and they are normally accessed through crossing networks or directly among market participants via private contractual arrangements. Some dark pools are available to the public and can be accessed via retail brokers.

One of the main advantages for institutional investors in using dark pools is for buying or selling large blocks of securities without showing their hand to others and thus avoiding market impact as neither the size of the trade nor the identity are revealed until the trade is filled.

However, it also means that some market participants are disadvantaged as they cannot see the trades before they are executed; prices are agreed upon by participants in the dark pools, so the market becomes no longer transparent.

In early November this year, Goldman Sachs agreed to outsource the day to day operations of its Sigma X dark pool platform for US stock trading to NASDAQ, representing the first time that a partnership of that type has ever taken place, and positioning the Goldman Sachs dark pool within one of the two largest operators in the US, thus creating an immune from it being knocked off its perch by a regulator.

Whilst the Securities and Exchange Commission (SEC) has recently strengthened its scrutiny of dark pools, it continues to approve of the ethos and modus operandi of large venues which operate them.

Under the agreement, NASDAQ will operate the software and hardware that underpins Sigma X, while Goldman Sachs will continue to own the platform and market it to the bank’s clients.

At the time, Goldman Sachs’ commercial statement on the partnership was “This partnership allows GS to capitalize on the expertise and experience of a scale provider of exchange technology used in 33 Nasdaq and many other marketplaces world-wide.”

Such a partnership with one of the pinnacles of dark pool operation, NASDAQ, may well be instrumental in aligning Goldman Sachs with Regulation Systems Compliance and Integrity, or Reg SCI, a set of SEC rules that took effect last year that aims to boost the reliability and cybersecurity of the U.S. stock market. Sigma X, the 10th-largest dark pool in the U.S., isn’t large enough to be covered by Reg SCI, but Goldman Sachs has been seeking to expand its market share.

Goldman Sachs is the first client Nasdaq has signed for its Ocean dark-pool-hosting business. The exchange operator has been pitching the service to banks and brokerages that run dark pools, offering to manage the back-end technology that powers them—which would help Nasdaq get a slice of the trading revenues that flow into the off-exchange venues.

This is just one example of how a venue which is subject to massive regulatory scrutiny and has a duty toward market transparency in the US, probably the most organized financial markets regulatory jurisdiction in the world, with the most transparent and technologically astute oversight, can partner with a large financial institution such as Goldman Sachs in order to bolster dark pool trading, unhindered by dissenters at regulatory level.

In Europe, things are somewhat different, however.

Just last week, Brian Schwieger, Global Head of Equities and Products at London Stock Exchange, which is an equally prominent venue among London’s giants and has just as much sway with large national regulatory bodies as NASDAQ does in North America, took a close look at what its major commercial priorities are in 2017.

Mr. Schwieger said “2017 will be the year that the industry moves into top gear preparing for MiFID II and we expect even greater focus given to the problem of working through the double volume caps. We have worked with our customers to launch and develop a suite of innovative new trading services whose adoption is already playing a significant role in the evolution of equities trading that we expect will gather momentum next year.”

According to the London Stock Exchange, the European Securities and Markets Authority (ESMA) is set to begin measuring the off-order book trading levels of dark pools on a daily basis from January 3, in order to take a close look at which stocks could be affected by the double volume caps which are scheduled to be invoked as part of MiFID II, which is the updated market infrastructure directive that is due to be set in place in the new year.

The idea behind this is to check how any caps on trading would affect certain listed derivatives for 6 months from January 2018.

Whilst Goldman Sachs has been able to make its way into a partnership with NASDAQ, effectively future-proofing its dark liquidity activities, European institutions have found themselves on the wrong side of the regulator’s favor in the United States.

Deutsche Bank, which is the world’s second largest provider of Tier 1 FX liquidity, got itself into some very hot water (excuse the pun) earlier this month when it was forced to admit to having misled customers about its dark pool stock-trading platforms.

The bank agreed to pay $37 million to settle a joint state and federal probe, bringing it a step closer to resolving several potentially costly legal challenges in the U.S.

The bank admitted to violating state and federal securities laws over a two-year period by failing to address known technical problems with its proprietary dark-pool ranking model, the U.S. Securities and Exchange Commission and New York Attorney General Eric Schneiderman confirmed in mid December.

This shows that European entities within North America that cannot behave according to the laws of the SEC will not be shown any leniency, however US entities are able to outsource dark liquidity to massive listed derivatives venues and technology providers such as NASDAQ.

Currently, three types of dark pools exist on the electronic markets.

The first type is where independent companies set up to offer a unique differentiated basis for trading, the second being broker-owned dark pools where clients of the broker interact, most commonly with other clients of the broker (possibly including its own proprietary traders) in conditions of anonymity, and the third being entities in which some public exchanges set up their own dark pools to allow their clients the benefits of anonymity and non-display of orders while offering an exchange “infrastructure”.

Depending on the precise way in which a “dark” pool operates and interacts with other venues, it may be considered, and indeed referred to by some vendors, as a “grey” pool.

These systems and strategies typically seek liquidity among open and closed trading venues, such as other alternative trading systems. As such, they are particularly useful for GPU-based algorithmic strategies. Dark pools have grown in importance since 2007, with dozens of different pools garnering a substantial portion of U.S. equity trading, and are massively widespread in Chicago and New York.

For this reason, as well as the US market familiarity with them and the regulatory prowess that fully understands them, 2017 may well be the year in which North American institutional dark pools flourish, and in which MiFID’s restrictions on European soil, and failure by European banks to operate according to US rulings may decimate European dark liquidity.