No clear path from the dark to the light – The TRADE poll

Market participants are divided over the likely fate of dark pools in 2011, according to the results of the January poll on
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Market participants are divided over the likely fate of dark pools in 2011, according to the results of the January poll on

Although 39% of survey respondents expected current regulatory and competitive developments to reduce trading volumes on non-lit venues, 31% disagreed, predicting an increase in dark execution, while three in ten readers thought there would be no significant effect.

Scrutinising the dark

The European Commission's consultation on possible changes to MiFID, launched on 8 December 2010, has proposed that broker crossing networks that enable third-party access should be reclassified as multilateral trading facilities (MTFs), while organised trading facilities – a new category which includes broker crossing networks – should become MTFs once they reach a certain level of business. The consultation also aims to tighten the rules on whether existing broker crossing networks should be registered as systematic internalisers.

The proposals follow widespread regulatory and political concern that the growth of off-exchange trading could damage price discovery and market transparency. But Natan Tiefenbrun, commercial director at London Stock Exchange-owned dark pool Turquoise, argues that suppressing dark pools through regulation could damage the entire market. “Rather than incentivising people to use the lit markets, some of the proposals do seem to focus more on precluding the alternatives,” he says. “Regulators should encourage the use of lit markets. But trying to squeeze the alternatives is not necessary or desirable. If brokers are obliged to show those orders to a greater extent, and that is not in the investor's interest, the investor may be more likely to simply withhold the orders from the market. Attempting to force liquidity onto a lit venue risks driving liquidity out of the market altogether.”

Citing a recent episode in which Canadian regulators placed restrictions on ”iceberg' orders – a type of algorithmic trading strategy that seeks to trade a large order little by little, keeping most of its bulk hidden – Tiefenbrun argues that regulatory attempts to increase displayed liquidity are often counterproductive. In Canada, liquidity temporarily flowed out, resulting in increased costs for investors and predictable market disruption. Icebergs were subsequently reintroduced.

Out of the frying pan

Regulators and politicians in Europe have also backed minimum order size limits for dark pools that use MiFID's reference price waiver. This prospect has been met with strong opposition from dark pool operators, while a number of buy-side heads of trading have expressed concern about the possible impact on execution quality. “There are many competing dark pools, and brokers look to interact with all of them to access the maximum liquidity for their clients,” says Tiefenbrun. “This could stop a broker searching for liquidity in an efficient manner – they would be less able to participate in external MTF-operated dark pools.”

Tiefenbrun sees the likely outcome of an imposition of order size limits as a shift in liquidity towards the broker crossing networks, as brokers may keep more order flow in their own pools and leave less in the MTF-operated dark pools, because they can no longer slice up their orders effectively. This could increase costs for market participants, he warns, as clients would face increased difficulty in finding the other side for their order.

He also points out that because MTF-operated dark pools publish trades in real time that are identifiable as coming from a mid-point order book, such transactions do contribute to price formation. “Applying an arbitrary minimum size to a child order doesn't make a lot of sense to me,“ Tiefenbrun adds.

Competition trumps all

Mike Seigne, co-head of Europe at Goldman Sachs Electronic Trading, suggests that dark trading may still see a limited increase during 2011, pointing out that the MiFID review is unlikely to result in enacted changes in the immediate future. Goldman Sachs is currently working on its own new dark pool, Sigma-X MTF, which is scheduled for launch in Q2 2011. The new offering will leverage a portion of the bank's internal liquidity and operate separately from its existing SIGMA internal crossing network.

Seigne acknowledges that effective execution across different types of venues is an ongoing challenge for market participants. “Competitive developments have seen clients combining their trading and quantitative expertise together with brokers. This, alongside the ability to access diverse liquidity from both lit and dark, has resulted in improved execution quality,” he says. Nevertheless, he also notes that too much restriction around large orders would be to the detriment of clients.

With UBS and Nomura having launched MTFs within the last 12 months to complement existing internalisation capabilities and new entrants such as PAVE and Quote MTF adding to competitive pressures, some market participants have questioned the value of a continued increase in the number dark pools operating in Europe.

The consultation on the MiFID review closes on 2 February 2011, with draft legislation scheduled for Q2 2011.