Buy-side urged to probe broker dark pools

European buy-side traders will have to analyse the crossing mechanisms operated by investment banks in more detail if recommendations by the Committee of European Securities Regulators (CESR) to shake-up broker dark pools are followed through.
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European buy-side traders will have to analyse the crossing mechanisms operated by investment banks in more detail if recommendations by the Committee of European Securities Regulators (CESR) to shake-up broker dark pools are followed through.

CESR, which aims for supervisory convergence across European securities markets, suggested to the European Commission (EC) in a recent advice paper that the internal dark pools operated by brokers should be reclassified as multilateral trading facilities (MTFs) if they reach a certain threshold. The advice paper is part of the EC-led process to reform MiFID.

Reclassifying broker crossing systems (BCS) as MTFs would no longer give the sell-side discretion over the type of flow that is allowed into their dark pool.

Up until now, many buy-side firms have tended not to analyse trading performance in BCSs, instead relying on brokers' best execution obligations under MiFID to ensure results. If the proposal is passed, traders will have to be more aware of where their orders are being routed and who they are interacting with.

“Many buy-side firms may be unaware of whether an order is routed to a broker's internal dark pool as part of an algorithmic strategy supplied by that broker,” said Carl James, head of fixed income and FX trading at asset manager BNP Paribas Investment Partners. “If a trader isn't aware that a broker dark pool has been reclassified as an MTF, the only way they are likely to change their trading strategy is if they notice a degradation in their transaction cost analysis results.”

Andrew Bowley, head of electronic trading product management at broker Nomura, notes that the differences between the internal crossing services offered by brokers mean the buy-side should already take notice of what's on offer.

“Some buy-side firms generally consider broker dark pools to be bundled in as part of an algorithmic strategy, which can mean traders are unaware of the type of liquidity they may be interacting with in these pools,” said Bowley. “With no clear distinction between systematic internalisers and broker crossing systems, this can impact execution performance.”

Under MiFID, “firms which, on an organised, frequent and systematic basis, deals on its own account by executing client orders outside a regulated market or multilateral trading facility”, should be classified as systematic internalisers (SIs). Broker crossing networks, on the other hand, are not defined under MiFID and can include client-to-client to trades, as well as the market-making activity that is typically found in SIs.

Trying to make this distinction between different types of BCS could become even more challenging if such systems are changed to MTFs.

“If broker dark pools are forced to become MTFs and open up their platforms, monitoring the flow that resides in them will be a lot more difficult compared to if brokers were just to collate different parts of the flow they have direct control over,” said Steve Wood, former global head of trading at Schroder Investment Management and founder of Global Buy-Side Trading Consultants. “The buy-side will have to analyse these venues like they would with other external venues.”

However, brokers may be able to exercise greater control over the liquidity in their internal pools should they become MTFs with differences in functionality, claims Nomura's Bowley.

“We believe there is a lot of concern amongst our competitors about the possibility of access being opened up if they are driven to the MTF model,” said Bowley. “We spent a lot of time developing the anti-gaming technology and pricing model for NX to preclude predatory behaviour and to ensure the flow that resides in NX is of a high quality.”

NX charges 2 basis points per execution, a lot higher than the 0.2 bps charged by Chi-Delta, the dark MTF operated by Chi-X Europe, for example.

Nomura reclassified its internal dark pool from a broker crossing network to an MTF in January this year because of commercial reasons. According to figures from data provider Thomson Reuters, NX traded €1.57 billion during July. Total dark MTF trading in Europe reached €17.24 billion last month.

If passed, CESR's recommendation will require BCSs to adhere to one of the pre-trade transparency waivers for trading venues under MiFID so that orders stay dark prior to execution.

Trading venues can remain dark if: the price for trades is derived from a reliable and widely published reference price, such as the primary exchange of a stock's listing; orders are above a certain size, defined on a stock-specific basis by CESR; or if trades are directly negotiated between two counterparties.

However, the final structure of broker dark pools will only become clear when there is more clarity on the threshold to be imposed.

“CESR's recommendation raises questions about whether brokers will be able to operate multiple crossing services that they can pass flow between to avoid becoming an MTF,” said Wood. “This is something that the EC will have to examine and can only be looked at when there are more details regarding the precise nature of the threshold.”