Complexity and diversity is making US dark pools a minefield for buy-side traders, creating suspicions on how brokers internalise orders.
Despite conversations with regulators on the role of dark liquidity, buy-side trading desks are frustrated with how their orders are managed and which pools they interact with.
Clive Williams, global head of equity trading at Baltimore-based T Rowe Price, believes regulators need to address dark trading to restore investor confidence, and drive activity back onto lit venues.
“Markets are far too complex and there’s confusion on the division between what a broker and what an exchange should be. Regulators need to give more clarity,” Williams said.
The trading head’s comments come after Richard Ketchum, CEO of the Financial Industry Regulatory Authority (FINRA), said the independent exchange regulator would step up its scrutiny of dark pools this year, while a US Senate hearing on market structure in December included issues related to dark liquidity.
Although the buy-side are now regaining trust in dark pools following the scandals that rocked venue operators Pipeline and LeveL ATS, investors are now worried about conflicting interests, particularly regarding brokers keen on growing internal pools of liquidity and reducing the fees paid to other venues.
As such, Williams believes the tenets of best execution have taken a back seat to the sell-side’s balance sheet.
“There’s been a disconnect between how the buy-side wants the order to be routed and what the sell-side wants according to their proprietary needs,” Williams said. “Brokers control their dark pools, so they’re going to monetise it as much as they can, by letting in more high-frequency flow, arguing that it’ll become more liquid.”
Justin Schack, managing director, market structure analysis for Rosenblatt Securities, suggests that some brokers may route orders to the cheapest venues first, potentially to the detriment of execution quality for clients, but asserts that buy-side firms must take a more proactive approach in analysing execution venues, rather than relying solely on broker insights.
Rosenblatt Securities' most recent monthly US securities volume report showed that off-exchange trades – both dark and OTC – reached 32.93% of total US equities volumes in 2012 according to data from trade reporting facilities. In 2011 the figure was 30.40%.
"The buy-side is becoming increasingly aware that they need to be educated about market structure and particularly how their orders are routed and handled by brokers," Schack said. He believes buy-side firms should look at how many shares are routed, how many are executed and in which venues to see which pools are giving best results, and ask brokers to route to those venues first.
But Williams points out the swathes of raw routing data that need to be analysed before understanding brokers' smart order routing decisions makes meaningful analysis almost impossible for institutional investors. The influential head trader wants regulators to reduce market complexity and mandate greater transparency of broker processes.
But Schack adds that if the buy-side are pinning hopes on new rules to govern broker use of dark pools, they may be waiting some time. Despite recent interest by the Senate and FINRA, Schack does not expect new dark pool regulation from the Securities and Exchange Commission (SEC) in the near future.
A three-point plan proposed by the SEC in 2009 to control the growth of dark pools has stalled. It proposed lowering the threshold at which alternative trading platforms must display bids and offers to 0.25% of a stock's average daily volume from 5% currently, the introduction of real-time disclosure of executions by all venues and new standards for reporting trades.
"The SEC is preoccupied with other things, like Dodd-Frank, limit up-limit down and the consolidated audit trail, which will take priority over any new dark pool rules," Schack said.
A more realistic push for change may come from exchanges themselves, who are fighting to maintain revenues and could increase lobbying efforts on US regulators to create minimum requirements for dark trading. Such a rule recently came into effect in Canada, which prioritises lit orders over dark and sets a minimum size requirement for dark trades.