How dark are the pools?

Improving market transparency has been a focus of  reforms post -financial crisis. As an increasingly important component of the market infrastructure, “dark pools” are inevitably part of the regulatory reviews currently under way across the globe.

In the U.S., the Securities and Exchange Commission (SEC) has published a consultation paper that discusses regulatory issues surrounding dark pools. In Europe, the Committee of European Securities Regulators (CESR) reviewed the directive proposed by the Markets in Financial Instruments Directive (MiFID) and their recommendation could have an impact on dark pool operations (http://www.cesr-eu.org/index.php?page=consultation_details&id=161). In Canada and Australia, papers have been published by regulatory organizations that discuss issues regarding dark pools.

So what are dark pools and where did they come from?

Dark pools emerged in the market in the late 1980s as the “upstairs” trading in formal exchanges. They cater to institutional investors, who occasionally need to trade sizeable positions in a company’s shares. By trading in a dark pool, where the order remains anonymous, investors can avoid adverse price movement in the market driven by the sheer size of the order. Early leaders in the dark pool market include Instinet, ITG, NYFIX, Pipeline and Liquidnet.[1] Through innovations such as continuous crossing and matching, dark pool operators helped clients fill their large orders with competitive pricing, attracting liquidity into dark pools. 

Spotting the opportunity for a new revenue stream and a chance to help clients reduce transaction costs, large investment banks joined the game and set up their own dark pools.  Examples include UBS MTF, Sigma X from Goldman and Crossfinder from Credit Suisse. One advantage that broker-dealers have over exchanges is “internalization.” When a broker-dealer can find among its clients both the buyer and seller of a share, the broker can simply match them internally instead of tapping into other dark pools. Another advantage is when the broker-dealer systemically matches clients’ orders against its own internal accounts.

More recently in Europe, after two years into MiFID, new market participants have emerged, taking advantage of MiFID derogations, such as the “reference price waiver” or “large-in-scale waiver.”  One advantage of this arrangement is that orders based on a published reference price generated by another system are not subject to pre-trade transparency.

According to the International Organization of Securities Commissions (IOSCO), a dark pool refers to any pool of liquidity that can be accessed electronically and provides no pre-trade transparency regarding orders received by (i.e., reside in) the pool. A dark pool may operate as an alternative trading system (ATS) (a term used in the U.S. and Canada), a multilateral trading facility (MTF) (a term used in Europe), a trading facility offered by a dealer (e.g., a crossing system/process), or a facility of a transparent market (such as an exchange). In general, dark pools operate with limited pre-trade transparency, in contrast to the “lit market.” 

IOSCO’s report “Principles for Dark Liquidity” in 2011 summarized the top reasons for participation in dark pools, including:

• Minimize information leakage
• Minimize market impact costs
• Facilitate the execution of large blocks, which may be difficult to achieve on transparent markets due to a lack of depth in the order book
• Ensure better control of an order
• Protect proprietary trading information
• Manage interaction with algorithms or programs that seek to identify or sniff out dark orders used in transparent markets
• Take advantage of the possibility of price improvement
• Minimize transaction costs

Dark pools accounted for a small fraction of trading volume when they started in the U.S. Since 2004, they have grown steadily over the years. In 2004, dark pools accounted for 2 percent of total U.S. trading; in 2008, the share grew to 8 percent and in 2012, it reached 12 percent, with 54 dark pools, according to TABB Group research. Dark pools in Canada did not experience the same success as they did in the U.S. By the end of 2010, two active dark pools in Canada only accounted for 2.4 percent of total volume. Europe followed a similar path as the U.S. However, the growth of dark pools in Europe has been more significant since 2005. In February 2012, 38 dark pools accounted for 8 percent of all European equity trading.

Overall, dark pools have provided the venue to meet large institutional investors’ needs to be able to trade anonymously with minimal market impact. Through new technologies, dark pool operators can also help their clients improve pricing and reduce transaction costs. Despite these benefits, dark pools are not exempt from regulatory concerns.

An earlier IOSCO review of dark pools raised the following concerns:

• Transparency and price discovery
• Fragmentation
• Knowledge of trading intentions
• Fair access
• Ability to assess actual trading volume in dark pools

The next two blogs in this three-part blog series on dark pools will provide an overview of the evolving regulatory landscapes in North America and Europe with respect to dark pools.

What benefits do you think dark pools offer large institutional investors? Join the discussion.

Capco's David Gest and Thomas Riesack contributed to this piece.

[1] Pipeline LLC was recently fined $1 million by U.S. regulators for misleading investors. It is revealed that Pipeline’s subsidiary was either the buyer or the seller for the vast majority of trades instead of matching client orders together as is supposed to happen for a block-crossing network.