With greater scrutiny in Europe, along with the US domination of dark liquidity, Jay Patani says “Barclays allegedly informed its clients that it monitored HFT activity, while in fact it did not run the weekly surveillance reports as advertised in the bank’s marketing material. The British bank also misrepresented the quality and type of market data feeds it used to calculate prices.”
Jay Patani is Technical Evangelist at ITRS Group, which provides real time monitoring and analytics solutions for Financial Services. He is based in Hong Kong and is a regular contributor to research and editorial in technology and finance.
When we think of dark pools, our minds are usually transported to Michael Lewis’ bestseller Flash Boys. Lewis’ book exposes the murky dealings of High Frequency Traders (HFTs) within dark pools, which are off-exchange platforms that allow traders to buy and sell stocks anonymously.
The sensational outpourings of Lewis’ Flash Boys are a frolicking ride for the reader but also made a substantial impact on how regulators view dark pools and high frequency trading. But dodgy dealings aside, there is still a valid argument for the existence of dark pools.
Why do they exist?
A major benefit is that market participants can trade without alerting the market of their intentions. The pools were originally created for this reason. For example, if an order of two million shares of a stock was fully visible, people on the other side of the trade could see the high demand and quickly drive up prices. This means that the trader would have to pay more for the stock than expected.
However, since the early days, average trade size in dark pools has fallen over time towards levels usually seen on exchanges. Another argument for dark pools is that they offer additional sources of liquidity thereby reducing transaction costs for the average investor.
However, there are plenty of concerns. While these private exchanges offer a haven for investors to trade large blocks of shares privately, there is a glaring transparency issue. Traditional exchanges are subject to strict regulation, whereas the opacity of dark pools’ activity sometimes give rise to conflicts of interest.
Operators of dark pools are part trading exchange and part market intermediary, which poses a challenge for regulators. Some dark pool operators have been criticized for directing their clients’ orders to their platform to exploit the higher fees.
There have also been numerous stories of high frequency traders (HFTs) collocating their computers with dark pools to access information faster. Relying on asymmetry of information, the HFTs capitalize on anticipating the intentions of other market participants and making lighting-fast trades at their expense. Brokers responsible for executing the orders have incentive to let this carry on as they get paid each time in the rapid stream of trades from HFT outfits.
The US dominates the world of dark pools, in which over 30% of total US trading volume takes place. In Europe, dark pools accounted for around 9 percent of European equity trading in July 2016. Although this is a mere shadow of activity in the US, it is a sizable 6.2 percentage point increase from 2010.
Fine after Fine
Dark pools have been under increasing regulatory scrutiny and have received record fines in recent years. In January 2016 Barclays and Credit Suisse, two of the largest operators of dark pools, agreed to pay a combined amount of $150 million to the U.S. Securities and Exchange Commission (SEC) and the New York Attorney General due to allegations that they deceived investors in their dark pools.
Barclays allegedly informed its clients that it monitored HFT activity, while in fact it did not run the weekly surveillance reports as advertised in the bank’s marketing material. The British bank also misrepresented the quality and type of market data feeds it used to calculate prices.
The SEC also reached a settlement with Investment Technology Group in August 20015 to pay $20.3 million for profiting from confidential information of customers in its dark pool. The regulator claimed that ITG, despite its self-proclaimed status of an ‘agency only’ broker, operated a proprietary trading desk. Furthermore, the prop desk used confidential customer information from the dark pools to benefit its HFT strategies.
A continuous string of dark pool misdemeanors have irked not only the regulatory but also market participants. In 2015, led by Fidelity, nine of the largest asset management formed its own dark pool called Luminex. As a ‘buy side only’ venue, Luminex already has over 150 subscribers, an average block size of 30,000 shares and already trading 2-3 million shares per day.
Regulators, rightly, have cast a suspicious glance upon dark pools but they also recognise that they are filling an economic gap. In a recent review, the UK’s Financial Conduct Authority (FCA) pointed out a few areas of improvement in terms of the transparency and monitoring of dark pools.
The FCA recommended that dark pool subscribers ensure that they conduct through due diligence on the operating model of a dark pool before joining. Similarly, dark pool operators should be under greater pressure to prove best execution, meet user preferences and monitor suspicious trading activity.
From January 2018, MiFID II regulation will impose stricter rules to strengthen transparency of dark pool activity. Asset managers must execute regular transactions on fully compliant venues. MiFID also imposes a volume cap on dark trading activity involving equity and equity-like instruments.
Individual venues trading using pre-trade transparency waivers have a cap of 4% of market volume. In addition, aggregated volume across all dark trading venues must not exceed 8% of total on-venue trading in the EU. Asset managers will also have greater reporting obligations and disclose the top five venues by execution volume as well as information on the trade execution quality.
Neither dark nor light
As the financial world marches forward into the new regulatory landscape, as ever, new financial innovations will spring up. With less than a year to prepare for MiFID II, dark pool operators are experimenting with more compliant alternatives, namely stock auctions.
“Semi-dark” stock auctions match buyers and sellers for larger trades, while still only publishing limited information on price and volumes. For example, Deutsche Boerse recently confirmed that it is closing its existing dark pool, Xetra Midpoint, in anticipation of new system that will focus on larger block trades and its Discovery Block Service.
The London Stock Exchange Group is similarly focusing on its daily midday auction, when trading at the exchange halts for two minutes to facilitate confidential trading between market participants. Its Turquoise Plato Block Discovery platform is already MiFID-II compliant and has traded more than 1.7 billion euros in January this year.
Dark pools are here to stay. Financial institutions are rarely embrace regulation with open arms but will always find clever alternatives. Dark pools will most likely face the wrath of MiFID but must scale down in the process. The two winners in all of this will be the lawyers (always ready to assist with regulatory matters) and the incoming wave of regulatory technologies (or ‘regtech’ startups), which will help banks and trading venues to adjust to new regulatory requirements.