Have multiple dark pools turned trading into a minefield?

European buy-side traders have recently been inundated with non-displayed trading venues that claim to improve execution performance via unique functionality. Competition between providers is healthy, but has the choice become overwhelming?
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European buy-side traders have recently been inundated with non-displayed trading venues that claim to improve execution performance via unique functionality. Competition between providers is healthy, but has the choice become overwhelming?

At the end of June, Baikal, a London Stock Exchange dark pool, launched its smart order routing function, while in May, multilateral trading facility (MTF) Nasdaq OMX Europe released NEURO Dark, a dark pool with an onward routing service and internalisation function. Fellow MTFs Turquoise and BATS Europe have also announced they will be launching their own take on the dark trading model within the coming weeks. Broker-owned dark pools are also coming thick and fast, one of the latest being Société Générale’s Alpha x pool, which is only accessible via the firm’s algorithms and sends orders to the public markets and crossing engine simultaneously.

A recent report from consultancy firm Celent noted that dark pools currently account for less than 0.5% of total European equity trading, suggesting that liquidity in individual pools could be thinly spread and crosses hard to come by.

However, Toby Bayliss, head of algorithmic and program trading, Europe, Sanford C. Bernstein told theTRADEnews.com that his clients have become more positive about finding partial fills in the dark, despite the numerous venues on offer.

“The way our clients have used dark algorithms has changed in the last five to six months and they seem a lot more confident they will find blue-chip liquidity in the dark,” said Bayliss. “Connecting to as many dark pools as possible is key to achieving higher fill rates.”

But with a range of different dark pool models to choose from, buy-side traders can afford to be more selective about which pools they use depending on their trading style.

Barclays Global Investors (BGI), which holds around $1.5 trillion assets under management (AUM) globally, is an example of a comparatively passive market participant, with orders that can have a time horizon of six months, according to Scott Cowling, head of equity trading at the asset management firm.

As a result, BGI sees more value in resting orders in those dark pools that are geared toward institutional, or block, size orders, rather than trying to tap as many dark venues as possible.

“From our experience and post-trade analysis, posting to all venues to aggressively seek a fill means you will probably miss out on a better opportunity to purchase a stock later in the day,” said Cowling. “We really use dark pools for orders that have a high liquidity demand, i.e. for a full day’s average daily volume in a stock. Pinging every single dark pool doesn’t do a great deal for our overall strategy.”

Jason McAleer, head of trading at Newton Asset Management, a buy-side firm that actively seeks liquidity, notes that firing orders to multiple venues can lead to greater information leakage and is detrimental to transparency.

“We have a good hit rate in the US, where sometimes 50% of an order can be executed in the dark,” said McAleer. “However, with such a low proportion traded in the dark in Europe, it is not entirely efficient to have so many venues. Trying to tap all of these sources creates a greater signalling risk.”

Signalling risk and the prospect of being gamed in a dark pool is something all buy-side traders should account for when using non-displayed venues.

“If you’re not trying to game the system, you are essentially missing an opportunity, and from that point of view everyone will try to get one up on each other,” commented one senior buy-side trader.

Tony Whalley, head of dealing and derivatives at Scottish Widows Investment Partnership (SWIP), an asset manager with £77.25 billion AUM, said that his firm assesses all dark pool functionality based on remits from individual clients and does not therefore see the array of venues available as a problem. SWIP is a part of pensions and investments group provider Scottish Widows, which also counts Lloyds TSB Insurance, Cheltenham and Gloucester and Lloyds Banking Group among its subsidiaries.

“We use both passive and aggressive styles of trading, depending on the order and the client,” said Whalley. “In the first instance, we would look to match business with the lowest possible market impact, then look to the multitude of other options available.”

Some market observers have suggested that tighter regulation of dark pools’ post-trade reporting could limit their use. The Financial Services Authority, the UK regulatory body, is widely tipped to standardise the reporting of dark pool trades – including the introduction of bilateral reporting standards – and increase the level of post-trade information that is disclosed. This could impact frequent users of specific dark pools, who may start to shy away from dark venues if other market participants know which venues they are likely to be using.

Buy-side traders, however, seem unfazed about stricter reporting requirements for dark pools. “Most dark pools generally cross small child-size orders that are instantly reported and as such, I don’t see any post-trade transparency issues with such forms of execution,” said Cowling.