The continued rise of dark pools in securities trading means that buy-side traders will have to move with the market, or be left behind, according to a panel of senior industry personalities at the TradeTech Europe conference in London.
“Our job as asset managers is to find liquidity,” said Tony Whalley, head of derivatives and dealing, Scottish Widows Investment Partnership. “The reality is, we need to use dark pools, otherwise we would risk missing out on crucial liquidity that we need to get the trade done.”
A study by TradeTech Pulse Research, released just ahead of this year’s TradeTech Europe, estimated that whereas prior to 2007, smaller and larger asset managers were trading on average just over 70% and 50-60% of their flow respectively on lit books, over the last five years all firms have reduced this on average by 5-10%.
Sheltering in the shade
Changes in market structure since MiFID introduced trading venue competition – including dark pools – in 2007 have caused average execution sizes in the UK to fall from £70,000 to £6,000, according to figures quoted by Whalley. The fragmentation of equity trading markets and the reduction in order sizes has increased the difficulty for buy-side firms to trade large blocks of stock – making dark pools a popular choice for many institutional investors.
“One of the most striking messages I have heard recently from senior voices on the buy-side is that the dark pool is the best place to trade in a bad environment,” said Niki Beattie, founding partner at consultancy Market Structure Partners.
Fear of information leakage and the possibility of being gamed by high-frequency traders are often cited as motives for long-only institutions placing their flow in dark pools. “We are using the dark more than before,” said Adrian Bradshaw, senior equity dealer at Invesco Perpetual. “If dark liquidity provides a good price and a good match for our needs, we are happy to use it.”
But not everyone agrees that institutional flow is any safer in non-displayed markets. Regulators in Europe and North America are often suspicious of dark trading, fearing that the practice runs against their preference for market transparency. And some observers assert that dark pools can contain high-frequency market making flow, while others suggest that the notion that dark trading is any better at concealing institutional block-sized flow than lit markets is a misconception.
“Dark pools are used to reduce information leakage, but they actually reveal more information about users than other forms of trading venue,” said Jon Ross, head of execution services at market making firm Getco. “Because of the kind of clients that use dark pools, you often know immediately that a buy-side firm is active and trying to trade a large block of a certain stock.”
Evolution or revolution?
For Beattie, dark liquidity is best seen as a continuation of existing OTC activity – and as such, is no worse than previous forms of trading that were widely accepted by regulators and market participants alike.
The effects of that automation vary from market to market. In the UK, the overall proportion of OTC activity is not changing significantly, according to Beattie. But in other markets, such as France, which removed its concentration rule recently, trading volume on lit exchanges have decreased significantly as more flow is now finding its way to the dark markets.
The European Parliament is currently discussing proposals as part of the MiFID II reforms to ban broker crossing networks (BCNs) – a controversial move, which has already encountered buy-side resistance on the grounds that it would restrict investor choice. BCNs would have to adopt either multilateral trading facility status – which would mean they would have to open up access to all market participants on a non-discretionary basis – or become a systematic internaliser, which would then prohibit them from matching client flow.
“Choice will continue to be a paramount concern for us on the buy-side to achieve best execution,” said Whalley. “I fear that regulators would tie down dark pools, so that they all become the same. That would not achieve anything – we need the choice of where and how to trade.”
However, Ross at Getco believes that once dark pools reach a certain size, it would be naive to ignore their potential impact on price discovery. “I’m not sure where the cut-off lies exactly,” he said. “But once they reach that point, they should move up to a higher tier of regulatory oversight and provide more information.”
Nevertheless, he is not concerned that dark pools could ever overtake the lit markets and become the dominant form of trading entirely. “There’s a natural equilibrium,” he said. “If all the liquidity is in the dark pools, you don’t believe the prices on the lit markets and vice-versa – so the liquidity will switch back again.”