US buy-side steps up dark pool due diligence

Institutional investors are bolstering their due diligence on dark pools in response to a recent sanction of a block-crossing venue in the United States.
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Institutional investors are bolstering their due diligence on dark pools in response to a recent sanction of a block-crossing venue in the United States.

US-based heads of trading at a number of buy-side firms said they were seeking further details on how their orders are being executed on dark pools and crossing networks after Pipeline Trading Systems and two of its senior executives were fined last week by the Securities and Exchange Commission (SEC) for failing to disclose that a high proportion of orders executed on behalf of buy-side customers in its US dark pool were filled by an affiliated trading firm.

“As a result of the news that Pipeline was sanctioned by the SEC, I conducted extra due diligence with all of our dark pool providers,” said Mark Kuzminskas, director of equity trading at buy-side firm Robeco Investment Management, echoing the views of several buy-siders spoken to by “It was important to discuss the present situation and enquire whether we executed against a prop desk or an affiliate of theirs.”

As part of his due diligence, Kuzminskas asked many brokers whether they routed order flow to Pipeline. “More often than not the answer was that they had little or no interaction,” he said.

Clive Williams, global head of equity trading at T Rowe Price, said in the past couple of weeks he had also re-ignited due diligence efforts, contacting dark pools and venues to examine their routing systems and relationships with affiliates and HFTs.

“It is extremely important to keep abreast of how the venues you use operate,” he said. “When the possibilities of how to execute a trade are endless, there are so many potential conflicts in the markets that you need to be aware of.”

Pipeline was fined US$1 million, while chief executive Fred Federspiel and chairman Alfred R. Berkeley III were each fined US$100,000. In settling the matter, Pipeline, Federspiel and Berkeley did not admit to or deny the SEC’s findings.

“In recent years, with increases in high frequency trading and the maker-taker fee structure, buy-side firms have been more aware of routing practices,” said Kuzminskas.

Other US trading venue operators said they had seen a mild uptick of due diligence enquiries from the buy-side in recent weeks but declined to comment on the record.

However, Morgan Stanley advocated greater transparency and information-sharing between dark pools and the buy-side.

“Morgan Stanley has always been vocal about the importance of transparency and the firm has had a consistent policy on order routing since the inception of its dark pool in 2006,” said Andrew Silverman, co-head of Morgan Stanley Electronic Trading.

In 2008, Morgan Stanley launched an information campaign called ‘Shades of Grey’ in a bid to educate buy-siders about what happens with their flow once it enters a dark pool. At the time, Silverman said dark did not always mean “completely dark”, observing that most dark liquidity pools should more accurately be described in various shades of grey, depending on how much information exchange they allow.

“Traders should understand the differences between these shades of grey because they offer a trade-off between liquidity and information leakage that may impact the stock. We have always believed not all liquidity is good liquidity, if you are leaving a footprint in every pool you touch,” said Silverman. “Clients are now much more aware of what happens in dark pools. They now have a more heightened sensitivity.”

The SEC said claims by Pipeline that its alternative trading system (ATS) provided institutional clients with “natural” trading opportunities and prevented “pre-trade information leakage” were “false and misleading”, given the presence of a trading affiliate on the other side of most trades.

Pipeline insisted clients had not been disadvantaged by the use of Milstream and the firm intended to offer clients the option of trading with the affiliate via an initiative called Pipeline Liquidity Pro.

Concern about the increase of trading in dark pools led the SEC to propose a three-point plan on 29 October 2009: lowering the threshold at which alternative trading platforms must display bids and offers to 0.25% of a stock’s average daily volume from 5%; introducing real-time disclosure of executions by all venues; and bringing reporting in line with registered exchanges.

The SEC supplemented these proposals in its equities market concept release on 13 January 2010, which floated the idea of a ‘trade-at’ rule which would prevent non-displayed venues from matching at the national best bid and offer (NBBO), and instead proposed that they should either match at a significantly improved price e.g. by the minimum tick size, or should route orders to a displayed venue that could complete the trade at the NBBO. The rule would prevent trades from being crossed in dark pools when that offered no advantage over crossing in a lit venue, but limited price formation.

However these proposals have been frozen, as regulators focus on implementing the many rules that were put in place by the Dodd-Frank Act, which came into law in July 2010.