The New Year is likely to bring increased regulatory pressure on off-exchange activity and high-frequency trading (HFT), according to market practitioners.
The past 12 months has been a rocky road for equity market participants, who have been faced with a spate of technology-related errors, new regulations and increased scrutiny of certain trading practices.
Buy-side traders will remain wary of using dark pools, as the lack of transparency associated with off-exchange flow comes increasingly under the microscope, according to David Mechner, CEO of algo provider Pragma. He believes brokers that operate dark pools will also face more questions on conflicts of interest.
"There's increasing concern that off-exchange volume is having a negative effect on the market. Internalisers are acting as filters, so low-quality flow ends up on exchange and high-quality flow is kept in these pools," said Mechner.
Mechner's view has been mirrored by Liquidnet, a block-trading dark pool operator. The firm foresees a rise in flow to broker-neutral platforms as part of its outlook for 2013.
"Increased scrutiny and regulation around broker sponsored dark pools will lead to a decline in volume in those venues. The number of execution brokers that asset managers use will continue to decline and the use of commission sharing agreements and sponsored brokers will increase," Liquidnet's predictions read.
For Mechner, the impact of recent errors by dark pools LeveL ATS, which failed to inform members its trade information was used by a third party, and Pipeline, which didn't tell members most orders were executed by an affiliated trading firm rather than other buy-side counterparts, have significantly dented trader confidence in dark pools.
In Europe, broker sponsored dark pools may be subject to new rules under MiFID II. Broker crossing networks (BCNs) may be included under the organised trading facility category in the directive, if European policymakers allow trading of equities in the new vene category. If not, BCNs would then have to define themselves as systemic internalisers or multilateral trading facilities.
In the US, legislators have sharpened their focus on dark pool activity, calling on a number of key industry leaders to outline the benefits and shortcomings of dark trading during a Senate committee hearing before Christmas.
The impact of HFT flow on markets will also see continued attention from market participants and regulators alike. In 2012, significant regulatory attention focused on HFT, such as provisions in the European Parliament's version of MiFID II. The document called for venues to instate order-to-trade ratios, a 500 millisecond minimum resting time for orders, and a ban of the maker-taker pricing model, which rewards posting passive liquidity but can lead to potential conflicts of interest among market participants.
Germany is also set to introduce separate legislation covering HFT firms early next year, while France has targeted the practice through a financial transaction tax, which it introduced for equity and derivative trades in August.
"Institutional investors will take a more active role in their choice of execution venues and turn to venues which meet their specific needs - those that provide deep liquidity in a HFT-free zone," Liquidnet stated in its predictions.
While market stability has been called into question multiple times this year after a variety of technological errors, the buy-side's adoption of electronic trading practices is predicted to rise further.
In March, BATS Global Markets was forced to cancel its IPO - the first on its own new listings service - after a software issue. A couple of month later, the hotly-anticipated Facebook IPO was delayed by around 30 minutes after an error at Nasdaq OMX left investors unsure of their exposures in the stock.
Then on 1 August, US market maker Knight Capital lost over US$440 million in little under 45 minutes due to problems with its market making system. Stock exchanges including NYSE Euronext and Nasdaq OMX were also forced to cancel trades in various stocks following technology glitches, adding to a growing catalogue of faults that makes uneasy reading for market participants and regulators alike.
But Pragma's Mechner believes the current trajectory of algo use for buy-side firms will continue, spreading beyond equities to other asset classes due to new OTC derivatives regulation in US and Europe that will mandate the central clearing of swaps and create new venues where they will have to be traded.
"As you see more OTC derivatives move onto exchanges or swap execution facilities [new trading venues established by Dodd-Frank for the trading of OTC derivatives] you'll see more automation and use of algos," said Mechner.