Profile: Andrew Morgan (2010)

DARK POOL GAZING…

Andrew Morgan, head of Deutsche Bank’s electronic trading platform for equities, Autobahn Equity Europe, talks to Best Execution about the impact of regulation, the need for a consolidated tape and why negative connotations about dark pools are undeserved.

Q. What impact do you think regulation has?

A. In coinciding with the credit crunch, MiFID and Reg NMS overlapped the most significant market dislocation that practitioners have experienced in their careers. This has had the effect of amplifying the regulatory scrutiny that the market faces. From an electronic trading standpoint recent history has shown us that technology increases the pace at which markets respond to regulation through competition and innovation. This brings additional features and functionality to the street but can also raise new questions for regulators if significant market structure changes are a consequence. The process is cyclical.

Q. In the current phase, what activities and players will regulators look at. Will they for example crackdown on high frequency traders?

A. It is my opinion that high frequency traders are an important source of liquidity for the market. Imagine what the liquidity and spreads would have been like if they had not been in the market after the credit crunch especially as other forms of liquidity had dried up. I think the regulators are right to conduct a review particularly as high frequency trading accounts for about half of the turnover in US equity markets and approximately 30% in Europe. However, the likely end result is that they will realise that there is nothing generally nefarious about the role they play. It is important to remember that the strategies pursued by high frequency traders, arbitrage and market making for example, are not new to the market. It is only the methods used to implement the strategies that have changed.

Q. What other issues do you think should be addressed?

A. We welcome the direction taken by CESR on Broker Crossing Services but unanswered questions remain. The advice paper (which is part of the MiFID review) suggests to the European Commission that internal broker dark pools should be reclassified as MTFs once they reach a yet to be defined volume threshold. This poses difficult practical questions. As for other issues, I would also like to see the emergence of a consolidated tape. Deutsche Bank has become a champion of this cause because it is one of the biggest concerns of our clients. Clear post trade data, benefits everything from transaction cost analysis to transparency and price formation, the quality of which makes a significant difference to investors. At the moment the complexity and cost makes it prohibitive for some customers to aggregate, clean and interpret the data.

Q. Touching upon dark pools, do you think they still have a negative connotation for the buyside or is there more acceptance?

A. I don’t think they have a negative connotation for the buyside since they are the principal beneficiaries of the existence of dark pools. The phrase “dark pool” sounds slightly sinister but they are not a new phenomenon. The function of the dark pool is to provide liquidity. What we have seen in Europe is an accelerated version of what happened in the US due to the combination of technical progress and regulatory change. Increasingly markets have become much more fragmented, fill sizes are smaller and trading is much more complex. I think the buyside are asking a lot more intelligent questions about the differences between dark pools and are increasingly aware of the value of features that manage the fill quality versus quantity trade-offs of indiscriminate dark pool usage.

Q. And what are those benefits?

A. The main advantage of dark pools is that institutional investors can execute a large order with less information leakage, lower impact and therefore at better prices. The buyside has always valued having the choice to display liquidity or maintain confidentiality depending on circumstances, all we’ve done is automate the traditional process of bringing large buyers and sellers together discreetly.

Q. How can they monitor dark pools?

A. There are about 20 different dark pools in Europe therefore paralysis, as a result of the paradox of choice, would be the likely outcome if traders were evaluating pools on an order by order basis. This is why they look towards a provider such as Deutsche Bank to access the liquidity in the smartest manner possible via products such as our Super X dark algorithm launched earlier this year.

There is a balance between quantity and quality of fill and the strategy aims to maximise fill rates while limiting information leakage and market impact according to client preferences. It consists of two components – a dark pool ranking model which ranks in real time the quality, quantity and cost of the fill offered by various dark venues as well as a dynamic return model which mitigates the risk of systematic adverse selection. This monitors the spread between the securities being traded and a closely correlated basket of securities and withdraws orders when unusual deviations are identified. The real time heavy lifting is performed by the algorithm and is fully backed up by transaction cost analysis that quantifies alpha preserved from use of the strategy.

Q. Can dark pools prevent investors from being affected by market inefficiencies such as the May 6th flash crash?

A. Protection from this type of incident can be derived from features as simple as a limit to sophisticated algorithmic tools that use quantitative momentum and mean reversion models to opt in and out of participation at certain price levels. Most investors understand this.

Q. Do you think that European dark pools will increase to the size of the US?

A. European dark pools will definitely increase in size because of the benefits they provide. Currently, according to the figures from the Financial Service Authority, they represent about 4% of total volume in Europe which is some way off the US which we think is around 12%. There is potential for a significant uptick in dark participation because liquidity begets liquidity, but it will take time as products mature and regulatory questions are answered. I think the buyside are asking a lot more intelligent questions about the differences between dark pools and are increasingly aware of the value of features.