By Cary Springfield – cary.springfield@internationalbanker.com
The alternative-trading systems known as dark pools are notorious for their opacity. They are often preferred by institutional investors who want to minimize the danger of information leakages when they conduct trades on the financial market; the pool’s principal purpose is to reduce as much as possible the impact that any trade conducted through it will have on the market by conducting the trade without disclosing any information about it. Prices for dark-pool transactions are only revealed, even to the participants, after the trade is settled, eliminating possible price fluctuations caused by other traders outside the pool. It was only to be expected that in the global drive towards greater financial-market transparency, watchdogs would sooner or later get to dark pools.
One of the reasons why regulators are turning the spotlight on dark pools is that the number of dark-pool operators has risen quite considerably in the past few years, making the segment even harder to keep tabs on than before. Naturally, this has affected the business of securities exchanges around the world, so they have joined in with regulators seeking to lift the veil on dark pools in order to improve investor confidence. The most recent initiative undertaken by exchanges and regulators is the formulation of the “trade at” rule, which would see tick sizes for securities increase in order to restrict dark-pool activity. This, according to supporters of the rule, would shed light on the startups that offer dark-pool trading but without the better price that, along with the privacy, is the major feature of these systems. So far, NASDAQ and NYSE Euronext have declared their support for the initiative. Separately, the London Stock Exchange is mulling over the launch of intraday auctions for a selection of highly liquid stock from the FTSE100 and FTSE250 indices, aiming to attract investors by luring them away from dark pools. According to FTSE Global Markets author Dave Simons, such measures could go towards exposing dark-pool upstarts that don’t offer any significant value to investors, something that is essential in boosting that same investor confidence that is haunting regulators the world over. However, it is still unclear how this trade-at rule, if and when it is adopted, would preserve the main advantages of dark pools over exchanges, such as a greater potential for product innovation, in the words of capital-markets consultant Saoirse Kennedy, and their role as a “relief mechanism for liquidity access concerns”.
While Simons, like many market participants, questions the idea that tighter regulation will necessarily improve the efficiency of dark pools by increasing the transparency of their operations, watchdogs are moving forward with regulation and penalization, too. Recently, one of the biggest dark-pool operators, Liquidnet, closed a $2-million settlement with the Securities and Exchange Commission in the US over improper use of private data about participants in its dark pool. According to the SEC, Liquidnet had let a business division outside of its alternative-trading system access this information, compromising one of the basic principles of dark pools. This outside unit, the Equity Capital Markets desk of Liquidnet, then used this information to market its own services in presentations and communications with other clients. The Wall Street Journal recently reported that the SEC has launched another probe into the segment. The watchdog will examine whether dark-pool operators inform their clients about their operations in a proper way and whether they are doing their best to protect their clients’ confidential information.
Undoubtedly, regulators are concerned about how investors are treated by dark-pool operators, but there is also a wider, more general concern, and it is about the overall stability of financial markets. SEC’s chairwoman, Mary Jo White, said at the beginning of June that there are concerns at the commission that the level of trading in dark pools may come to “seriously undermine the quality of the US market”. This level is indeed considerable. Figures from Rosenblatt Securities based on research from last November reveal that the total securities trade outside of exchanges in the US accounted for 37.5 percent of overall trading. Of this, 14.5 percent were trades executed in dark pools. It is understandable, therefore, that financial-market authorities are eager to make these trading venues more transparent and controllable. There are concerns now that SEC’s latest investigation could lead to the commission enacting rules that would see more trade move to exchanges, not just from dark pools but from other off-exchange venues as well. There is also the danger – from dark-pool operators’ point of view – of being forced to divulge information revealing their treatment of investors and possibly sparking doubts that this treatment was fair.
As regards information disclosure, at the beginning of June, the Financial Industry Regulatory Authority (FINRA) started providing data about the activity levels of dark-pool and other off-exchange venues to the general public. In its official announcement, FINRA said this will improve the level of transparency regarding off-exchange trades. Until June 2, dark-pool trades were disclosed through securities-information processors in real time but were only available to investors and financial-market professionals. Also, this information concerned trades in bulk, with no pointers as to the amount of trade conducted by each individual dark pool. With the new initiative, the general public will have access to data revealing how much stock, by security, was traded each week at any given off-exchange venue.
The situation is no more favourable for dark-pool operators in Europe. The revised Markets in Financial Instruments Directive (MiFID II), which was recently approved by the relevant EU authorities, stipulates that dark-pool trading should be capped at 4 percent and 8 percent. The 4-percent restriction relates to total trades per security in one dark pool, while the 8-percent cap regards the share of dark-pool trading in the total consolidated amount of trades in a given stock over one day. According to institutional investors in Europe, this cap will in effect force them to turn to exchange-traded securities. Forceful or not, the stipulation is in line with European regulators’ drive towards channeling as much financial-market trading as possible through exchanges and also enforcing stricter rules for off-exchange activity.
Transparency and investor confidence are the buzzwords for financial-market authorities on both sides of the Atlantic, and it would be safe to say that they will not relinquish their grip on dark pools in the near future. It is in fact most likely that they will look to tighten it further.