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.”
[divider_adv topwidth=”3″ bottomwidth=”3″ linecolor=”#4e5780″ ]
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.”
[divider_adv topwidth=”3″ bottomwidth=”3″ linecolor=”#4e5780″ ]
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.”
[divider_adv topwidth=”3″ bottomwidth=”3″ linecolor=”#4e5780″ ]
©BestExecution 2013
Tony Freeman, global head of industry relations at Omgeo, says T2S and CSDR are forcing firms to rethink their operations. “Accommodating T+2 settlement will involve an insignificant technology change for the big buyside firms, but the non-automated segment of that sector will need to address the change. Operationally it will have a big impact on them,” he says. Sellside firms, he adds, are talking to their buyside clients about post-trade automation in a much more serious fashion than previously. “A move to T+2 involves extra cost and risk if you are using manual processes. This has given sellside firms the incentive to go to their buyside clients and say ‘this might not work in T+2’.”
In the long term, securities firms will benefit from the introduction of T+2, says Geoffroy Vander Linden, head of product management at Xtrakter, the trade matching subsidiary of MarketAxess, operator of an electronic trading platform for US and European corporate bonds. T+2 settlement will deliver reduced back office costs via harmonised settlement times and a consolidation of CSD venues. However, in the short term, the moves will lead to increased costs as firms will have to adapt their systems to meet the T+2 settlement cycle.
“Europe is being more ambitious than the US in converging rules for OTC and exchange traded derivative (ETD contracts), which may drive OTC volume onto standardised exchange based instruments,” says Jeremy Taylor, specialist in operational processing and derivatives at Rule Financial. “It also has a broader remit, but regional regulators have a slightly different interpretation of the rules. However, if we do not get harmonisation across both Europe and the US, then we will not have a level playing field and this will have unintended consequences for the way the landscape of the market evolves.”
Jonathan Philp, capital markets consultant at everis adds, “There are still a lot of loose ends on both sides of the Atlantic but there has been a lot of frustration in Europe because ESMA has not yet approved any of the trade repositories, and there is still confusion over the final scope for listed derivatives reporting. I think that ESMA will approve a minimum of two TRs before the end of 2013, perhaps the DTCC and REGIS-TR, which will allow market participants to finalise their preparations for trade reporting starting in the 1st quarter of 2014.”
It is not surprising given the more muted tones that collateral management may not be the revenue generator that many broker dealers had hoped. “I think the sellside is waiting for the dust to settle before they fully recalibrate their models,” says Bradley Wood, partner at GreySpark Partners. “Collateral optimisation has been talked about but it is not yet a done deal. At the moment banks have sufficient liquidity to offset any trade exposure and they are not yet using their inventories. As for the buyside, they may prefer to trade liquidity swaps in the beginning.”
KNOWLEDGE IS POWER.
New rules, introduced under the Dodd-Frank Act, require that financial institutions record their mobile communications, including calls and texts. Here, Paul Liesching, Senior Vice-President of Truphone Mobile Recording, explains the new regulations and how firms can meet the challenges.
The end of commission payments for research. Source: TABB Group
FACING UP TO THE ELEPHANT IN THE ROOM – THE END OF COMMISSION PAYMENTS FOR RESEARCH
Martin Wheatley, CEO of the UK’s Financial Services Authority, clearly outlined his intentions on Wednesday when he announced that the FCA will conduct a rigorous review of the use of client commissions to pay for research. While the debate about how client commissions can be used has been a long and contentious argument going back to the Myners Report of 2003 (CP176 document), it would appear that this time, definitive change isunderway.
The FCA is right – there are inherent flaws in the current process that need to be addressed. While many asset management firms are actively taking steps to address how client commissions are used – enabling them to achieve best execution as well as gain access to the best research – there is still room for improvement from many.
The Divorce Between Research and Execution
As we highlighted last year (see: “The Long-Awaited Divorce: European Research and Execution Go Their Separate Ways”), the industry has remained in gridlock.UK brokers are believed to have resisted the move toward the full unbundling of commissions out of fear that fund managers would no longer be willing to pay them for research. While there has been a growing movement to distance the execution decision from the research decision, how does the industry establish what research is worth? Should asset managers simply use their own money to buy external research for an agreed price? Would that finally allow pure, independent research providers to gain a foothold? Some would argue that already is taking place – look at the meteoric rise of new research firms such as Redburn, Autonomous and Monument. (Ironically, these independent research providers might also find themselves the subject of consolidation.)