Buy-side traders have heightened their scrutiny of order activity in broker dark pools in Europe and the US, but clearer guidelines from regulators may also improve transparency.
Institutional investors that send orders to broker dark pools often feel inadequately informed about how orders are routed, as well as the type of non-client flow that resides in each because of the differences in crossing models and order handling practices used by the sell-side.
In Europe, broker crossing systems (BCSs) are not specifically recognised or regulated by MiFID and can include both client and internal flow. Unlike multilateral trading facilities (MTFs), brokers can restrict access to internal crossing engines and have flexibility on the price at which orders can be matched. Most dark MTFs in Europe, such as NYSE Euronext-owned SmartPool and Chi-X Europe's Chi-Delta, are currently required to match orders at the midpoint.
By contrast, brokers operating dark pools in the US are governed by the same rules that exist for alternative trading systems, which have similarities to MTFs but can control access, match orders within the spread and report trades anonymously.
In both the US and Europe, ambiguity over the rules that cover broker's internal crossing mechanisms has left the model open to interpretation, which has led to more buy-side inquiries on how their orders will be handled.
“In the last nine months, we have spent a lot of time answering questionnaires from the buy-side on how orders are handled within our PIN crossing network,” observes Owain Self, global head of algorithmic trading, UBS. “Clearer guidelines on the activities brokers can conduct in their MTF or BCS will help to achieve a more coordinated dark pool regime.”
As well as its PIN crossing service, UBS will launch UBS MTF, in Q4 2010 after receiving approval from UK regulator the Financial Services Authority on 17 August.
While many broker-operated dark pools seem to match orders similarly, further examination reveals small differences that could affect buy-side execution performance.
For example, UBS, Morgan Stanley, Credit Suisse and Goldman Sachs all enable access to their dark pools via proprietary algorithms only, which gives them discretion over how orders are handled and prohibits access from non-clients. Furthermore, each firm claims not to disseminate indications of interest (IOIs) to third parties such as electronic market makers from their respective pools, which enables them to be completely dark and free, in theory, from information leakage.
However, UBS states that only its client-facing trading businesses are allowed to send flow to PIN, while Credit Suisse's Crossfinder and Goldman Sachs' SIGMA – known as SIGMA X in the US – integrate a wider selection of internal flow into their dark pools.
UBS matches orders in PIN at the midpoint, while Credit Suisse and Goldman Sachs execute flow at anywhere within the spread.
“If a client has an order to trade at a specific price where displayed liquidity is available in the market, they may cross this internally with a broker at the same price,” said Self. “We choose not to do this, as the aim of PIN is to optimise execution by providing price improvement via crossing at midpoint.”
Morgan Stanley seeks to differentiate its offering, MS Pool, by stipulating a minimum order size and minimum resting period to facilitate larger crosses compared to displayed markets.
Eleanor Jenkins, vice president and head of liquidity strategy at Morgan Stanley, notes that high broker crossing rates could also indicate that a wider range of external participants have access to client flow.
“If a broker has an unusually high crossing rate in their broker crossing system, they may be sending out actionable IOIs and market their flow to electronic market makers,” she said. “High-frequency traders can use this information and execute against client flow, which potentially provides good execution results. But the key is for clients to obtain transparency as to the way their orders are managed and the flow they interact with.”
Jenkins adds that advertising flow from broker dark pools to other participants is a US trend that is becoming increasingly popular in Europe. Self at UBS says that current liquidity levels in Europe could justify approaches that maximise crossing rates.
“As clients demand for liquidity continues to grow, the perceived quality of different forms of liquidity can change from order to order and the access that brokers provide needs to evolve.” he said. “One of the reasons behind establishing UBS MTF was to open up a broader pool that could include additional ”latent liquidity' within the firm and its trading partners, without compromising the types of liquidity in UBS PIN. This gives greater choice to the client.”
Responsibility for determining how orders interact with broker dark pools should fall on the buy-side.
“There is certainly room for greater transparency in how individual broker dark pools operate, but ultimately it’s up to all market participants to understand the specifics in fulfilling their best execution obligations,” said Rob Maher, head of sales for Credit Suisse's Advanced Execution Services division in EMEA. “It should be no different than asking your traditional voice brokers the right questions in terms of how they handle your order flow.”
But the rules governing broker crossing systems are set for reform on both sides of the Atlantic. In Europe, the Committee of European Securities Regulators (CESR), which is responsible for coordinating securities regulation across the continent, published technical advice on 29 July designed to help the European Commission as it gears up for a review of MiFID. The recommendations included a tightening up of oversight of broker crossing networks, centred on greater post-trade transparency to both regulators and market participants and imposing a limit on the amount of business a BCS can execute before it is required to reclassify as an MTF.
Jenkins considers the measures proposed by CESR to be a step in the right direction.
“Per the MiFID II proposals, if brokers are required to register their broker crossing systems with regulators and provide transparency on their crossing methodology, the differences between model types will become more obvious,” said Jenkins.
In the US, regulatory body the Securities and Exchange Commission has also laid out a three-point plan for reforming dark trading systems, in a bid to shed greater light on dark pool practices. These comprise a need for actionable IOIs sent by dark pools to be published in the same way as actual quotes; lowering the level at which dark pools must make quotes public to 0.25% of a stock's average daily traded volume from 5%; and forcing dark pools to report trading volumes individually on the consolidated tape. All three proposals included an exemption for orders of $200,000 or more.
But Andrew Silverman, managing director, Morgan Stanley, does not think the proposals, particularly for IOIs, will bring any more comfort to the buy-side.
“The bottom line is that all firms operating dark pools or broker crossing systems should disclose their order handling practices. If the SEC bans actionable IOIs, those using them can instead use immediate-or-cancel order types to determine the trading interest residing in dark pools,” said Silverman. “US buy-side firms are currently sceptical of how orders are handled by brokers. Any regulation should focus on how to add more transparency to the marketplace.”