Nomura move reopens dark pool debate

Nomura’s decision to reclassify its internal dark pool as a multilateral trading facility (MTF) has reignited the debate on how broker-owned crossing networks should be governed, with observers predicting regulatory intervention or increased liquidity sharing.
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Nomura’s decision to reclassify its internal dark pool as a multilateral trading facility (MTF) has reignited the debate on how broker-owned crossing networks should be governed, with observers predicting regulatory intervention or increased liquidity sharing.

The Japan-based investment bank announced last week that its NX internal crossing engine would become the first dark pool owned by a full-service broker to be regulated as an MTF. Nomura hopes to establish NX among the leading dark liquidity venues in Europe by volume. But becoming an MTF entails significant changes in how a trading venue operates. All MTFs are required to publish post-trade prices immediately after a trade is completed and must also enable access to all market participants.

The categorisation of broker-owned venues has been hotly disputed by exchanges and brokers for some time. The Federation of European Stock Exchanges (FESE), a trade body representing Europe’s exchanges, has argued that brokers’ internal crossing engines should be regulated in the same way as exchanges or multilateral trading facilities as they perform similar functions.

Under MiFID, trading venues can fall under one of three categories: regulated investment exchanges; MTFs; and systematic internalisers (SI), defined as an investment firms that deal on their own account by executing customer order flow in a frequent and systematic manner. MiFID permits brokers to undertake over-the-counter (OTC) trades on the understanding that they are ad hoc, irregular and carried out with wholesale counterparties outside of the systems used for SI business. The SI category was created specifically for broker dark pools but so far only ten brokers have registered, according to Markit BOAT, an OTC reporting venue. Nomura has said it will continue to operate a risk-provision SI service distinct from NX. Morgan Stanley has opted against SI classification for its dark pool, MS Pool, for legal reasons.

“Brokers whose crossing networks match orders on a multilateral basis should run their platforms in line with the associated set of rules, even if they consider these rules to be a bit cumbersome or costly,” Burçak Inel, deputy secretary general, FESE, told “Some banks may find it commercially less advantageous to run their dark pools as MTFs, but that is a separate question to whether they owe it to investors to run it as an MTF.”

Inel believes reclassification of broker-owned venues that trade on a multilateral basis would lead to fairer competition between trading venues, improve price discovery and transparency, impose better market surveillance on broker engines and lead to fair and equal access for investors.

“Based on how an MTF is defined under MiFID, we think a number of brokers should follow Nomura’s lead. The MTF category is a perfectly suitable framework for broker-dealer pools that want to match multilateral trades, which can be lit, dark, large or small, and limit market impact,” said Inel.

Brokers, however, have argued that the MTF category is not suitable for their dark pools, adding that control over eligible liquidity is crucial to achieving best execution for clients.

“There is clearly a distinction between broker business and an MTF,” comments Eleanor Jenkins, vice president and head of liquidity strategy at Morgan Stanley Electronic Trading. “From our point of view, the most important factor is having discretion, which allows us to provide our clients with the level of service and type of liquidity they expect, in terms of controlling average trade size fills and making sure our pool is 100% dark.”

However, Jenkins does note that a tightening of existing regulation around pre- and post-trade transparency guidelines for OTC and other trading venues may provide clarity on price formation. But regulatory action is unlikely without accurate figures on the level of business crossed by brokers.

Data on the level of business conducted on broker venues is currently limited. FESE estimates that 40% of European trading is conducted OTC, with 10-12% of this figure transacted in broker pools, while brokers say it is closer to 4-6%. The Committee of European Securities Regulators has begun collecting data from brokers including Morgan Stanley and Credit Suisse to reach a more precise figure before deciding whether to recommend regulatory action to the European Commission.

Nomura has said that the reclassification of NX was done for commercial rather than regulatory reasons, i.e. to attract more flow. “Having MTF status allows us to interact more cleanly with other dark pools and expand our own pool of liquidity with flow from other market participants,” said Adam Toms, head of the market access group, EMEA, Nomura, said last week.

But brokers that have already built up a critical mass in their internal pools may be less keen to reclassify as MTFs.

“It’s a logical step for Nomura. By being regulated as an MTF they might entice flow from participants that could have previously been reluctant to use broker-owned dark pools,” said Sören Steinert, head of trading at Quoniam Asset Management, a German investment house with €10 billion assets under management. “When you compare single-broker dark pools with the Goldman Sachs, Morgan Stanley and UBS tie-up, they are all pretty small in comparison in terms of flow and crossing rate.”

Goldman Sachs, UBS and Morgan Stanley announced a liquidity sharing deal in May 2008, allowing each bank to become an algorithmic trading client of the other two. For example, UBS uses Morgan Stanley algorithms to access MS Pool.

Steinert says he will encourage his brokers to connect to NX when it goes live as an MTF on 25 January 2010, but still expects to route orders to the combined liquidity pool of UBS, Morgan Stanley and Goldman Sachs in the first instance.

“The next big question will be how brokers without liquidity-sharing agreements will respond, whether they come together or attract flow by following Nomura’s lead. This will become more clear in the New Year, but there is now pressure on brokers to act,” he said.