A SHOT IN THE DARK.

Broker dark pools are being squeezed by new rules but market participants are divided over whether there is a problem with, or a misunderstanding of, the unlit market. Dan Barnes investigates.

Authorities want a clearer understanding of what goes on in dark pools. American, Australian and Canadian regulators have set out requirements for increased transparency and responsibility for these trading venues. Now Europe is set to clamp down on their operation under a revision of the Markets in Financial Instruments Directive (MiFID).

“What we are going to see in Europe following MiFID II, is that it becomes increasingly difficult to transact in a broker dark pool,” says Mark Hemsley, CEO of BATS Chi-X Europe, an MTF and dark pool operator. “We may see more MTFs being created, or more trades being conducted by systematic internalisation.”

Dark venues, which may be run by brokers or market operators, do not display the orders they have received before trades take place, unlike traditional exchanges. Typically pools run by exchanges, electronic communication networks (ECNs) and multilateral trading facilities (MTFs), are bound by some market regulation. However dark pools that are run by brokers are regulated lightly, if at all.

In the US, trading in broker dark pools accounted for 15% of consolidated equity trading in July, according to Rosenblatt Securities, while research firm Tabb estimates that around 10% of European volume is conducted in the dark.

Dark pools offer one way of hiding these big orders and that makes it harder for firms using HFT to trade ahead of them. Despite this legitimate value, regulators have voiced disquiet. There is the potential for activity to take place that could interfere with orderly markets or reduce the social usefulness that capital markets provide. The inability to see the prices at which firms are trading in the dark can interfere with other firms’ price formation; if the size of dark trading is significant, the price distortion could be significant.

“If some large percentage of trades are happening away from where traders have to display price quotes, then how valid are those price quotes?” asks Justin Schack, partner at broker and market structure specialist, Rosenblatt Securities.

Disclosure

FINRA is not alone. Following a review of the market that exposed misleading practices by dark pool operators (see box 2), Australian Securities and Investment Commission (ASIC) inflicted a requirement on dark pools to trade at the midpoint or to trade with significant price improvement in May, and in August has set out a series of disclosures that it will require broker dark pools to make from November 2013.

Per Lovén, head of international corporate strategy at buy-side block trading dark pool Liquidnet Europe says that what ASIC found in Australia would also be found in other markets if regulators looked.

“I absolutely believe that, and we think that the rules ASIC imposed are very healthy for the market as a whole,” he says.

Canada too has imposed price improvement on non-block-sized orders and increased exposure on dark pools. The European Parliament is currently debating how dark trading will be treated under the revision of the Markets in Financial Instruments Directive and Regulation (MiFID II & MiFIR).

“ASIC wants to address these issues before dark trading reaches the levels we’re seeing now in the US,” says Schack. “That is why they put rules in place, and why the Canadians did what they did in October, and why the expectation is that in Europe there will be significant changes to the way dark pools are allowed to operate, which may result in less activity occurring away from displayed markets.”

Blurring of the lines

An issue cited by some on the sell-side is that a lack of standardised terminology can lead to genuine confusion between investors, regulators and brokers around the activity that is being described.

Rob Crane, co-head of electronic trading for EMEA at Goldman Sachs, says, “Ultimately as an industry we have got to get a more consistent meaning for commonly used terms. This would help everyone get more transparency on who, where and on what basis liquidity is being sourced. Then, rather than trying to characterise participants as “good” or “bad”, you can categorise orders by intention, and then choose on what terms you want to interact with other liquidity, such as by contra order size, price or urgency for example.”

However in some cases there is also a deliberate blurring of the lines say many market participants. Ex-proprietary traders can be found taking positions for the bank in dark pools under the disguise of market making, a supposedly client-centric activity. Hedge funds managers have expressed surprise at some broker dark pool activity; one found the position taking of a US broker in its own dark pool was no different to that of his own fund’s proprietary trading. Another quant fund manager turned off access to a major European broker’s dark pool because “it was so toxic.”

Owain Self, global head of direct execution at broker UBS says, “Some firms have additional flow in their pool coming directly from trading desks where their aim is to internalise flow or capture spread. This would be electronic market making. They may allow external firms the same access, with the aim to provide liquidity in response to opportunity. We do not allow either internal or external market making in our broker crossing pool PIN, all the flow is from execution algo’s only, from clients/internal books which is considered to be natural, has pre-determined intent to execute and is not reactive.”

 The right rule

Regulation can influence the use of dark pools in a targeted manner; Australian and Canadian rules have moved liquidity away from the dark and into the lit, in both cases around 4-5% of total market share.

“Initially we saw a fairly significant fall in what was classified broadly as dark liquidity,” says Clare Witts, a director at ITG Asia. “However it affected particular participants. We didn’t see a particular drop in volume on our mid-point crossing engine, which is typically buy-side peers crossing large orders; the change isn’t really targeting that flow.”

Europe will now have to determine how big a problem it has with dark pools and to what extent they need reining in. The process is made more difficult due to the uncertainty around the size of the market, inhibited by the lack of standardised trade reporting, says Hemsley.

“There isn’t a common trade reporting set of rules and we won’t have one in Europe until the approved publication arrangement (APA) comes in under MiFID,” he says. “That means getting precise stats about what happens in dark pools is difficult, and that is before you get to definitions of how you count trades.”

Some of these challenges will be addressed once MiFID II is put in place, for example the proposed consolidated tape of stock prices will allow a clearer understanding of where trades take place.

However Andrew Bowley, head of business operations & risk at agency broker Instinet Europe, warns that setting legislation in stone ahead of the clarity the tape will bring could create serious problems.

“One of the ideas that has come out of the European Council discussions is that dark pools should be capped once reaching 8% of a stock’s volume, but that number seems rather arbitrary,” he says. “It also makes sense to use the consolidated tape to reference the appropriate level, and also give ESMA the ability to tweak that percentage if necessary based on the data.”

Based on the impact across other markets, it seems unavoidable that a tightening of Europe’s rules will cut back on dark liquidity.

“Regulation of control, supervision and access, the more structural things will have an impact on the market,” says Self. “I think there will be less people operating pools because the operational burden of doing that will become cumbersome.”

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Under the spotlight

Several issues with dark pools were exposed last year in the US:

Pipeline, a block-trading dark pool operated by a broker dealer, shut down in 2012, having been the subject of an investigation by US regulator the Securities and Exchanges Commission (SEC). In October 2011 it was fined US$1 million for failing to match customer orders with one another “naturally” as it claimed to, instead crossing them with affiliate Milstream Strategy Group which in turn “sought to predict the trading intentions of Pipeline’s customers and trade elsewhere in the same direction as customers before filling their orders on Pipeline’s platform,” according to the SEC.

Concerns were raised around Liquidnet in 2012 when the SEC said it had disclosed too much information on its users to corporations whose shares were traded on the platform, an issue CEO Seth Merrin described as an error of “omission not commission”

In October 2012 the SEC charged eBX, operator of the LeveL ATS dark pool was discovered to be routing an outside firm’s flow to fill orders with other LeveL users, whilst supplied with information on how subscribers’ orders were priced. eBX settled the charges with a US$800,000 fine.

“When the SEC did reviews of pools a few years ago there were both intentional and unintentional structures within some dark pools which didn’t fit the rules,” says Owain Self, UBS. “There were also inconsistencies with what pools told their customers they were doing and what they were actually doing.”

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Australian rules

Australian Securities and Investment Commission, ASIC’s review of the market in Q3 2012 found that for dark pools in which the operators traded, the broker-client trading accounted for an average 38% of volume.

It found this was often not disclosed to clients, noting in its report that crossing system operators claim to provide ‘natural liquidity’ or as containing no high-frequency trading (HFT), “Yet there are cases where there appears to be active facilitation, proprietary trading or HFT interacting with client orders. Some crossing system operators allow, or have previously allowed, access to their crossing systems by clients that the industry widely considers to be high-frequency traders while maintaining there is no high-frequency trading in their crossing system.”

ASIC also noted that “Many crossing system operators are not disclosing where there is a market-maker operating within their crossing system.”

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