Investment banking profits and banking bonuses have caused distaste in the mouths of many over the last few years. Understandably, regulators and politicians have needed to be seen taking greater control.
"Against a backdrop of bonuses, high-frequency trading and dark pool bashing, they [regulators] must avoid the temptation to score populist points without necessarily understanding the full implications and mechanics of the product or service in question."
Overly complex products created over exposure for investors and required banking bailouts. In a climate where many individuals have suffered while the banks rebound, this has understandably created some cause for concern.
I would caution that regulators and politicians should be guided appropriately. Against a backdrop of bonuses, high-frequency trading and dark pool bashing, they must avoid the temptation to score populist points without necessarily understanding the full implications and mechanics of the product or service in question.
Take dark pools. Dark trading has existed as a practice for years, often by other names: internal crossing, upstairs trading, ‘over the counter’ or OTC trading. On the UK sell side even before the advent of the LSE SETS orderbook in October 1997, if a large institutional order came in, a broker would potentially find an internal match desk to desk or ring other sell-side brokers and buy-side clients to find the other side. With the advent of order-driven trading, this practice continued but with the additional option to work part of the order in the public markets.
Dark pools today are an “electronification” of what was previously a manual telephone-based process.
This practice has served a very important function. Different trades need different strategies.
For some smaller sized orders for highly liquid stocks, sending them to the primary market of listing and to the visible books of the MTFs may be the best approach. For other larger sized orders, particularly when trading less liquid stocks, it may take considerably longer to find the other side of the trade.
One of the greatest threats to any trading strategy is signalling risk. Flagging your trading intentions can seriously compromise the trading of any order and over the years brokers have found ways to minimize this risk. Use of dark pools is one of the means to help achieve this to the benefit of the end client. Additionally, as capital has become scarce over the last few years, many banks do not take as many proprietary positions by giving a buy-side client a fill on risk at a competitive rate for a large block and instead choose to try and find a natural counterpart for the order where ever they can.
Most savvy buy-side clients want their brokers to tap into both displayed and non-displayed liquidity for any given stock in the most efficient way possible, which can include the use of exchange/MTF displayed and non-displayed order books, broker dark pools and independent dark pools through effective smart order routing. All these liquidity sources present a means to get your business done if used in the right fashion and the key objective should be the achievement of best execution.
Too often one sees trades being done at worse prices on some venues than are available on others. It is this that the regulators should really focus on as part of MiFID II given that best execution under MiFID is too principles based, making this difficult to prove and measure.
There is much debate here in Europe. As a result of the European Commission’s (EC) consultation process for MiFID II, some changes are inevitable in the way that dark pools will be regulated.Measures that include size restrictions on dark orders and a requirement to reclassify all broker dark pools as MTFs/Systematic Internalisers or OTFs (Organized Trading Facility) – although the existence of the OTF classification is still being debated – are likely to receive strong political support.
The commission is looking at the role of dark pools in the broader context of a review of the impact of MiFID regulation. And they are being lobbied hard by the exchanges, who claim that broker dark pools are unregulated and need to have some form of classification, be it a Systematic Internaliser (SI), MTF or some new definition. Many investment banks that run many such pools argue that they are the most heavily regulated entities in the world and these pools are operated under that regulatory scrutiny and therefore such arguments do not reflect reality. Additionally, many buy-side firms would argue that restricting use of dark pools will restrict trading as a result of the market impact of trading solely in lit environments.
"It is not surprising that we hear arguments against dark pools being presented by many of the exchanges via the Federation of European Stock Exchanges (FESE)."
Irrespective of the arguments against more stringent regulation of dark pools, the new European Securities and Markets Authority (ESMA) will be given a high degree of regulatory power as a result of which we can expect a more formal, less flexible approach to pre-transparency waivers across the EU, albeit more consistently administered.
It is not surprising that we hear arguments against dark pools being presented by many of the exchanges via the Federation of European Stock Exchanges (FESE). With the onset of MiFID they have seen a great deal of competition and as a result reduced profitability and increased questions over their business models and practices. A small number of savvy exchanges are starting to become more efficient by reducing costs and innovating but the vast majority are finding it hard to break away from the monopoly mindset and find it far easier to go on the defensive.
Another area of concern expressed by FESE is that they believe that dark trading could account for over 40 percent of all European trading based on publicly available data. I would caution there is likely a large degree of double counting (a matter that does need to be addressed in terms of more defined reporting rules relating to post-trade data and an accurate European consolidated tape) and I don’t believe that the numbers are anywhere close to these.
The Association of Financial Markets in Europe (AFME), which represents the investment banks, recently defended against these claims and said in a statement in April: “The current reporting requirements cause confusion and can result in misleading claims, as our research shows. This is of concern as it suggests that policy decisions are driven by misinformation or misunderstanding.”
The findings of their study suggest that only 16 percent of trades take place in dark pools. If we drill down into this further to look at BATS Europe market share data for dark pool MTFs, the five-day average in early June reveals that only 2.67 percent of all European exchange trading was done in dark pools.
I believe in the price discovery that displayed books provide but also that in small doses, non displayed liquidity performs an important function for institutional order flow. I support the industry’s efforts for increased transparency and the initial approaches to voluntary disclosure to third parties such as TABB Group or Rosenblatt Securities are to be encouraged.
Well defined pragmatic standards are also welcomed. On May 24, the Technical Committee of the International Organisation of Securities Commission (IOSCO) published a report mapping out a number of principles to assist regulators, venues and market participants to deal with dark pool MTFs and dark orders entered into transparent trading venues. While those on opposite sides of the debate will not agree with all aspects of this, they at least represent a step in the right direction as far as trying to introduce consistent standards and workable regulation. An important point is also that these proposals state that there is no one size fits all solution.
Dark pool trading is good for the market as a whole but this strategy must be used in the right fashion to achieve best execution for the end client. I believe that the current principles-based regulation for best execution is insufficient and while I do not want this to be as prescriptive as Reg NMS in the U.S., it is important that clear, common guidelines be provided to prove execution performance.
About the Author
Hirander Misra is the co-founder of both companies and is responsible for running Algo Technologies to deliver specialist high speed trading technology solutions which include extremely low latency distributed raw and normalised market data (AlgoData), matching technology with the world’s fastest independently verified matching engine (AlgoM2) and shortest path inter exchange network connectivity (AlgoSpan) with the added advantage of expert market structure consultancy services.