Regulation

Shine a light

Like the old safe sex mantra (it's not who you've slept with, it's who they've slept with, and who they've slept with...) the caveat to trading in the dark is that you don't know for certain what happens behind closed doors.

In more innocent times, a trader that wanted to execute off-exchange would put in a call to his broker's upstairs desk in the hope that his order could be matched ”naturally' against another institutional client. Now the trading partner could be chosen from a much wider universe and even the scantest of details may not be available after the event. If a buy-side trader sends an order to a dark pool, that order could get routed to other pools which may operate under different rules; it could interact with short-term traders or indications of interest could be sent out to attract the other side.

Regular buy-side participants seem relatively comfortable adding parameters to an order to limit its interaction in the dark. But some asset managers express concern about the limited post-trade information that they receive on their dark orders. The increased range of non-displayed execution options means that buy-side firms are increasingly keen to understand why orders are placed where they are placed, to adjust their behaviour to improve performance.

This can be difficult. European OTC equity trades are reported by brokers and dark pool operators to the Markit BOAT reporting facility or a primary exchange. In the US, they are reported to the consolidated tape. In neither case does the system help the buy-side trader to identify the venue on which the trade crossed.

A FIX identifier – Tag 30 – can be used to identify the final execution venue but if this is labelled differently by brokers, or simply as ”OTC' with no differentiation between the order interacting with a swap or a broker dark pool, it is of limited value.

Regulators in the US and Europe have set out proposals to increase post-trade transparency in dark pools. The US regulator, the Securities and Exchanges Commission, proposed in October 2009 that dark venues (and all other alternative trading systems) must report their trades on the US consolidated tape in real time with the venue identified.

An exemption to these rules would be granted for orders over $200,000, to allow block traders to maintain anonymity.

The European Commission (EC), in its review of MiFID launched on 8 December 2010, has proposed the introduction of a consolidated tape that would improve post-trade transparency.

A prerequisite to the construction of a consolidated tape is the creation of approved publication arrangements to standardise the reporting of trades. This will bring welcome clarity to the OTC market. As there are currently no standards in place, measuring the size of the market is difficult because trades can be double counted or categorised differently depending on who reports them and where.

The EC has also suggested that post-trade reports be published as close to real time as possible for regulated markets, multilateral trading facilities and organised trading facilities, a new catch-all category which includes broker crossing networks, with some exceptions for large transactions. It also asks whether the flagging of OTC trades to identify where trades occur could be useful.

The standardisation of trade reporting and the flagging of trades in Europe has broadly been welcomed, by buy-side and sell-side alike.

However there is concern in both the US and Europe that venue-specific data released on a real-time basis from dark pools would increase information leakage and could play into the hands of firms that trade on a high-frequency basis.

By analysing the data and segregating OTC activity into types and by venue, a firm that has the technology to react on a real-time basis may be able to build up bigger pictures of other market participants' trading activity for its own advantage.

As long as trading performance can be reviewed, Buy-side firms need to put execution data under the microscope to improve performance and brokers can be held to account. But too much disclosure could reveal trading performance and strategy in too public a manner.

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