Trading in dark pools and periodic auctions lowers execution costs, FCA paper concludes

Analysis from the UK’s regulator has said that dark trading, which the EU has restricted under MiFID II rules, can reduce costs for investors.

Investors can save on execution costs by trading in venues that the EU has tried to restrict or ban, a paper from the UK’s financial watchdog had concluded.

Trading in dark pools and periodic auctions can reduce transaction costs while more transparent venues incur higher costs and implementation shortfall, the research from the Financial Conduct Authority (FCA) said.

In one example, the FCA said that when dark trading is not subject to bans a 10% increase in the proportion of a parent order executed in a dark venue reduces implementation shortfall by 0.97 bps.

Executing on periodic auction venues produces a similar reduction in transaction costs, with savings of 1.17 bps for a 10% increase in proportion traded, the analysis of more than 58,000 parent orders from almost 1,000 market participants found.

“We find venue selection decisions matter,” the FCA’s paper said. “We find that the higher the proportion of dark or large-in-scale dark executions in the parent order, the lower its implementation shortfall. We also find that periodic batch auctions reduce implementation shortfall when dark pools are banned.”

The findings contradict similar research from the EU which has made efforts to restrict trading in dark pools to increase activity that occurs on pre-trade transparent or ‘lit’ venues. The EU introduced double volume caps (DVCs) in 2018 under MiFID II that trigger bans on dark trading when a transaction reaches a certain size.

The European Securities and Markets Authority (ESMA) stated in a review of MiFID II that the DVCs have had a limited, but overall positive effect on market liquidity. Market participants, however, have been vocal with criticisms on the move by regulators in Europe to curb dark trading, which they say allows for minimal market impact and often the best price for clients.

Similarly, periodic auctions came under intense regulatory scrutiny after ESMA expressed concerns that the venues were being used to circumvent the rules on dark trading. Amid fears the EU watchdog would ban periodic auctions, ESMA eventually opted to make changes to how the systems should operate.

The UK’s regulator has already said it will lift restrictions on dark trading for investors in a bid to attract more business in a post-Brexit world. A post-Brexit equivalence agreement was also reached on stock exchanges between the UK and Switzerland, which will increase activity for Swiss stocks on UK venues.

“It is likely that the DVC policy did not affect transaction costs because substitutes like periodic auction-based venues are available,” the FCA paper added. “Importantly, after the ban is lifted, we find participant volume moves back to dark pools, implying perhaps that participants prefer dark pools to periodic auctions when both options are available.”