When weighing up the pros and cons of trading in non-displayed venues, the ability of the pool operator to control participation – and thus offer an additional layer of comfort to institutional investors – can be a substantial differentiator.
But the MiFID consultation launched by the European Commission last week could narrow choice by proposing the reclassification of broker crossing networks.
One of the main advantages of trading in the dark for institutional investors, that of limiting market impact of a big trade, is neutralised if the buy-side firm runs the risk of being gamed by high-frequency trading (HFT) firms that have been alerted to a large block trade. While most HFT takes place on lit venues, buy-side firms suspect that the high percentage of cancellations in many high-frequency strategies are designed to seek out order-size information that can be then used against them.
Broker-operated dark pools offer a level of protection that non-displayed venues run as a multilateral trading facility (MTF) cannot. While MTFs can discourage HFT flow either through pricing or by introducing functionality such as ”fair value' checks or minimum acceptable quantity limits, they are unable to bring down the shutters completely. Under MiFID, the M of multilateral is not taken lightly.
By contrast, brokers can operate their pools according to their own rules. As they require the use of their own proprietary algorithms for firms to access their dark pools and as such they are able analyse and segregate order flow relatively easily.
There is plenty of anecdotal evidence to support the view that the buy-side is reluctant to trade with HFT firms. But a report from research firm TABB Group, ”European Equity Trading 2010: Manoeuvring in the dark', found that 76% of European respondents and 72% of UK respondents were neutral as to the effect of HFT on trading costs. TABB also found that more liquidity was the greatest improvement that the majority (63%) of buy-side traders could see in darks pools; only 23% were concerned about being gamed.
Buy-side only dark pools exclude HFT flow though the use of a size limit for orders. But this can potentially limit liquidity. Thus for some buy-side firms the discretionary nature of broker dark pools offers a sense of security, without cutting out the valuable liquidity that HFT firms can offer.
The EC's MiFID consultation has recommended the reclassification of broker crossing networks as MTFs if they interact with outside flow or as systematic internalisers if trades are executed against proprietary capital, removing these options from the market. That could leave buy-side firms either without current means of access to liquidity or protection from gaming. Either way the best execution is endangered by the lack of choice.
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