Buy-side dealers are increasingly trading away from lit markets but regulators want to limit the extent of this dark trading. Nicholas Pratt examines whether the industry is set for a collision.
The dark is getting darker. Figures from various sources report an increase in the amount of trading by buy-side firms taking place off-exchange, or ‘dark’ venues. A report into dark trading from research firm Celent, Dark Pools: In the Eye of the Storm, says that were more trading to move to the dark in the next few years, it could raise “great concern” for the future of lit markets.
The report identifies three main types of dark pools: the exchange-sponsored pools, such as Turquoise, which is operated by the London Stock Exchange and targets high frequency traders; the broker-owned dark pools, like UBS, which offer buy-side traders preferred liquidity; and the independent dark pools like ITG and Liquidnet, which specialise in reduced market impact for block trades.
The great concern mentioned in the report and shared by regulators is that too much trading on dark pools will mean too little on lit markets, making it harder for investors and traders to obtain price formation and discovery.
Another concern is the reduced size of trades in dark pools. While large block trades are ideally suited to dark pools and unlikely to have ever been traded in lit markets because of the market impact, regulators are worried that smaller trades, which should be traded on lit markets, are being traded in the dark and, again, harming price discovery.
However, despite these concerns, the report concludes that the current levels of dark pool trading in the US and Europe, which is estimated to be around 11% of total trades, are not sufficiently high to require a regulatory intervention, especially when weighed against the benefits to end investors.
“Mandatory reporting requirements on trading volumes would be appropriate at this stage. Getting a clearer understanding of trading behaviour in dark pools, improved transparency and information sharing with clients for broker-dealer-sponsored dark pools should be the focus areas at this stage,” says Muralidhar Dasar, Celent analyst and co-author of the report.
This view is shared by the investment community which was concerned enough to send a letter to the European Commission. The signatories included three global asset managers (Fidelity, State Street Global Advisors and BlackRock), three investor associations (the UK’s Investment Management Association, the Association of British Insurers and the European Fund and Asset Management Association) and even an exchange (the LSE), albeit one with its own dark pool.
The letter called on the EC regulators to reconsider its proposal to limit the extent of dark trading, including the plan to introduce caps on the volume of dark trading within the EU via the new Markets in Financial Instruments Directive (MiFID II), which proposes a 4% cap on any particular stock and an 8% cap on any dark venue.
But these hopes were seemingly dashed when it was reported on November 22 that the MiFID II board had voted to accept the proposed volume caps.
“It is not a workable compromise,” says Arjun Singh-Muchelle, capital markets expert at the UK Investment Managers Association, of the volume cap.
“One buy-side manager could fill the 4% quota with a single trade. But how will others trade off-exchange to get the best price for their clients? Do they go to the lit market where they get a worse price, or internalise the trade where there is even less transparency? Or, do they not trade at all? Once again it will be the investor that will lose out.”
There are further outstanding issues. Will large trades be outside the scope of MiFID II? Will broker crossing networks be exempt? Both would account for a significant portion of the volume traded in dark pools.
Instead of imposing volume caps on dark pools, says Muchelle, the question should be why buy-side managers choose to trade in the dark in the first place and how lit markets can be made more attractive to the buy-side?
“We have made a number of suggestions such as mandating the use of FIX [financial information exchange] protocols to ensure better post-trade transparency. We also want to ensure there is flexibility for Esma [the European Securities and Markets Authority] to change the MiFID II rules if they prove to have an adverse effect on price or liquidity.”
The market is currently in what Rob Boardman, European chief executive of ITG, calls a twilight zone where the time for lobbying is at an end but there is a wait for the final details. One concern that Boardman has is that if these decisions are made quickly, they will not be fully thought through. “It could bring chaos to the markets. Esma needs time to calibrate the changes and brokers need to make changes to their systems in terms of algorithms, SORs and connectivity.”
“We are in favour of dark trading and crossing being properly regulated and subject to fair access. The process has become politically confused by the lobbying of the exchanges and dazzled by the concept of transparency.”
He adds: “Transparency is great but in the securities markets it will sometimes mean investors are left playing poker with their cards face up.”
Boardman says not every trade has to be transparent and regulators have to balance “the paranoia about market integrity” with the possibility of higher trading costs. “It feels to me that the whole argument has been calibrated too far in favour of exchanges and not investors. And it is a shame because it could cost investors real money.”
Per Loven, head of corporate strategy and product at Liquidnet Europe, appreciates the benefit of a well-functioning price discovery process in the lit markets, which is also used as a price reference point for the dark markets. However, the generally accepted figure of 11% as the extent of dark trading in the equities markets, is not enough to warrant regulatory intervention, especially as there is as much as 40% of trading conducted on an over-the-counter basis which does not contribute to price discovery either.
The challenge is to make sure that the right kind of trading is taking place in the dark pools, such as large block trades, or executions, taking place at mid-point, thereby reducing market impact or offering price improvement. This is in contrast to small trades executed at either bid or offer which could often just as easily be executed on lit markets. “We believe that if you use a dark pool you should be able to add value over and above the lit markets.”
This approach, whereby dark trading is limited to block trades and trades offering price improvement, has been adopted by regulators in Canada and Australia and, says Loven, resulted in an increase in lit trading and dark block trading and a decrease in dark smaller trades, exactly the result policy makers wanted to achieve.
European regulation and its volume caps are totally the wrong way to go, he says.
“In the past year, we have seen the European macro-environment improving, and more fund flows coming into European equity markets thereby fuelling overall economic growth. At this point it would be much better to focus on creating more efficient equities markets rather than increased regulatory hurdles.”
The next few months will be crucial, he adds.
“We will continue to try and influence on behalf of the buy-side but there are a number of commercial interests at play here and it seems like certain exchanges are looking to regain market share through regulation rather than competition.”
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