Let There Be Dark

By Huw Gronow, Head of Equity Trading, Europe and Asia, Principal Global Investors.
Sometimes an industry adopts mysterious-sounding labels to add to the intrigue of its complexity. It may well be that market historians will regard the use of the term “dark pools” as an error of PR.
“Dark pools” burst into the public consciousness not with the adoption of Regulation ATS in the US, nor with MiFID in Europe, but with the publication of Michael Lewis’ “Flash Boys” in April this year.
Whereas “non-displayed liquidity traded in an exchange-like venue under a pre-trade transparency waiver” may not sound as sexy (few would argue against that) the negative connotations surrounding the venues have reverberated through to regulators and law makers alike, we believe to the potential detriment of the end investor.
For institutions such as Principal Global Investors¹, with USD326bn under management², being able to transact large positions with minimal market impact is critical to managing the risk transfer associated with portfolio implementation.
In Europe, non-displayed liquidity can be most simplistically categorised into either “small dark” or “large dark”, that is, small executions either in public dark books (MTFs) or private broker crossing networks (BCNs). Then there are “large in scale” blocks transacted in institutional pools where the trade sizes are many multiples of the average trade sizes in the lit venues (and indeed the dark MTFs and BCNs, for the most part).
The choice of “dark” or “lit” environments, or a combination of the two at any time, and indeed the way you interact with a dark environment, is chiefly dependent on your catalyst for trading.
Trade urgency dictates how much you use the dark, not only in relation to your desire for certainty of execution, but the way you interact in the dark is also a function of your urgency to trade. In short, it is not as straightforward as either “lit” or “dark”. Many, as we do, interact with both for differing catalysts and at different stages in the trade cycle, and this nuance does not seem to be well understood when regulation is being considered.
Fundamentally, the main benefit of the non-displayed environment to institutions like us is that we’re able to place large orders out for execution, at the time of our choosing, that would otherwise send a clear signal to the market of our intent.
Indeed, even if those large orders are atomized to reflect the microscopic size of the trades in the modern ecosystem, predictability is the enemy. Smart usage of dark pools protects us to some extent (not totally in our view) from that.
MiFIDII looks like it is going to potentially change the landscape radically however.
The policy makers seem keen to increase transparency in the market, with concerns over impact to the price discovery process if too much trading volume is in the “dark”. We argue that the ability to transact without publicly showing our hand provides real and quantifiable benefits to institutional portfolios, which are ultimately often held by retail investors, the persons whom MiFID was designed to protect. There is hope, however. The Large in Scale Waiver under MiFID remains unaffected by the dark pool “caps” that are proposed to limit the percentage of smaller trades that take place under the Reference Price Waiver and it is already apparent that the buy-side are looking to take control.
The name “dark pools” implies something bad? It has been said already that it may be high time to call them something else. The concept of the buy-side driven Turquoise Block Discovery Service is a great example of the right response by the buy-side, sell-side and a forward-thinking exchange-like venue not only to likely changes in regulation but designing a system geared towards the benefit of the end investor – the public investing for their retirement. And it does not sound nearly as sinister. Maybe that’s the point?