Apr 8, 2016

In today’s financial markets, dark pools have become a topic of controversy amongst financial regulators.  As the financial world increasingly relies on speed of trading, both regulators and investors face the challenge of finding a balance between permissible trading and manipulation aimed at generating unfair profits.[1] Due to the exponential growth in volume of trading over the past decade through dark pool trading, regulators have had no choice but to investigate. With several upcoming regulations attempting to govern this space, will this previously opaque area of finance continue to be as widespread – and as profitable?

What are Dark Pools?

Dark pools are private exchanges for trading securities. These pools are operated by brokers, exchanges and electronic market makers. Unlike public exchanges, dark pools lack transparency. Orders and trades are not publicly displayed and are not reported until after they are executed. Dark pools, in theory, allow institutional investors to buy or sell large block orders without revealing their intention to other participants and minimise the effect on price a large trade would otherwise have.

[1]Henning P. Markets Evolve, as Does Financial Fraud. DealBook. 2016. Available at: http://dealbook.nytimes.com/2013/11/11/markets-evolve-as-does-financial-fraud/?_r=1.

By restricting access to undesired market participants and by not revealing quotes, dark pools enable institutional investors to minimise their information leakage and realise more efficient executions. More specifically, dark trading facilities provide the possibility of price improvement and reduced transaction costs by crossing orders at the midpoint of the quoted best bid and offer prices, thereby saving on both the bid-offer spread and on exchange fees.[1]

The Rise of Dark Pool Trading 

Although dark pools have been around since the late 1980s, the controversy surrounding them has never been greater than it is today. Dark pools began to proliferate with the passage of the Regulation Alternative Trading Systems rule in 1998, which was expanded seven years later with the Regulation National Market System, also known as Reg NMS. Together, they introduced new rules to improve access to quote information, ensure fairer prices for investors and were aimed at. The changes caused a proliferation in electronic trading networks, significantly cutting trading costs. Non-exchange trading in the U.S. has surged in recent years, accounting for about 40% of all U.S. stock trades in 2014 compared with 16% in 2008. According to Reuters, there are approximately 45 dark pools in operation today,[2] which have been at the forefront of this trend towards off-exchange trading and account for 15% of U.S. trade volume as of 2014.[3]

[1] Lexicon.ft.com. Dark Pools Definition from Financial Times Lexicon. 2016. Available at: http://lexicon.ft.com/Term?term=dark-pools

[2] http://www.cbsnews.com/news/finances-dark-pools-explained/

[3] http://www.investopedia.com/articles/markets/050614/introduction-dark-pools.asp

Problems Associated with Dark Pools

While dark pools have their benefits, they certainly have their flaws. High frequency trading is at the top of this list. Dark pools are always vulnerable to predatory pricing by high frequency trading. High frequency traders rely on complex algorithms and speed, which allows them to detect incoming orders from other participants. They can place small orders themselves, which when picked up reveal the intentions of other participants, and can profit by using this information to front run larger orders and execute millions of trades ahead of the public. Furthermore, HF traders use ultra-fast telecom links, microwave towers and pay for special access to exchanges, which enables them to gain an edge over their competitors. They can buy or sell large amounts of stock microseconds ahead of ordinary investors, profiting through speed.

Furthermore, dark pools lack transparency. Unlike public exchanges, everything, from who involved in the trade, how large the trade is and even the price is kept from others. This lack of transparency makes it difficult to police, because it can be hard to track down exactly what types of orders were entered and whether or not they were part of ordinary market-making activity or an effort to manipulate the system. Large amounts of activity in dark pools can make prices on public exchanges less accurate, due to investors on the public exchanges being unaware of what is happening in dark pools and leading to a risk that the price on the public exchange is not the ‘true’ price.

Even as they’ve captured a bigger slice of U.S. stock trading, dark pools have faced less regulation than public exchanges. Regulators are taking steps to change that. The 2012 SEC’s proposal for a mega-database, the Consolidated Audit Trail, has yet to become anything other than a proposal, but would record each and every “order, cancellation, modification, and trade execution for all exchange-listed equities and equity options across all U.S. markets”. This database could prevent insider trading and regulate the activity of dark pools.[1] However, the most promising regulation falls within MiFID II. Under MiFID II, dark pool trading taking place under a reference price waiver (which allows certain transparency requirements to be avoided) will be subject to two volume caps:

  • A limit of 4% on the amount of trading in a stock that can be carried out on a single dark pool.
  • A limit of 8% on the amount of trading in a stock that can be traded across all dark pools.

The caps will be calculated using trade data from the previous 12 months and any stock that breaches the limit with be banned from trading on a dark pool for six months. Therefore, all trading venues will be required to start sending data to European regulators twice monthly from January 2016, to enable the caps to be introduced when MiFID II comes into force. The European Securities and Markets Authority will publicly announce each month if the thresholds have

[1] Laurent G. The Future of Dark Pools. The Market Mogul. 2016. Available at: http://themarketmogul.com/the-future-of-dark-pools-2/.

less regulation than public exchanges. Regulators are taking steps to change that. The 2012 SEC’s proposal for a mega-database, the Consolidated Audit Trail, has yet to become anything other than a proposal, but would record each and every “order, cancellation, modification, and trade execution for all exchange-listed equities and equity options across all U.S. markets”. This database could prevent insider trading and regulate the activity of dark pools.[1] However, the most promising regulation falls within MiFID II. Under MiFID II, dark pool trading taking place under a reference price waiver (which allows certain transparency requirements to be avoided) will be subject to two volume caps:

  • A limit of 4% on the amount of trading in a stock that can be carried out on a single dark pool.
  • A limit of 8% on the amount of trading in a stock that can be traded across all dark pools.

The caps will be calculated using trade data from the previous 12 months and any stock that breaches the limit with be banned from trading on a dark pool for six months. Therefore, all trading venues will be required to start sending data to European regulators twice monthly from January 2016, to enable the caps to be introduced when MiFID II comes into force. The European Securities and Markets Authority will publicly announce each month if the thresholds have been breached.[2] However, MiFID II volume caps may themselves cause issues. A survey carried out by the London Stock Exchange has suggested that almost all of the FTSE 100 stocks would exceed these thresholds.[3] Similar research by Bats Chi-X Europe – an equities exchange – has found that the majority of blue-chip stocks would also be affected.[4] This will certainly be something to keep an eye on if and when MiFID II is implemented.

What Does the Future Look Like for Dark Pools?

While CAT seems to have been left in the past, MiFID II could certainly be a step in the right direction in regulating dark pool trading in years to come. However, for now, uncertainty remains. The market will spend 2016 and 2017 preparing for what could be a major change while considering what options it can take. Even with new regulations upcoming, there will be traders and firms who will continue attempting to manipulate prices and arbitrage, as for now it is still extremely lucrative.

[1] Laurent G. The Future of Dark Pools. The Market Mogul. 2016. Available at: http://themarketmogul.com/the-future-of-dark-pools-2/.

[2] Cave T. New Shades On Way for EU Dark Pool Trading. Rosenblatt Securities Inc :: News. 2015. Available at: http://www.rblt.com/news_details.aspx?id=265

[3] http://www.efinancialnews.com/story/2015-04-15/eu-dark-pools-caps-would-hit-nearly-all-ftse-100

[4] Dudhia A. Mind the cap: dark trading under MiFID II | RegTechFS. Regtechfscom. 2016. Available at: http://regtechfs.com/mind-the-cap-dark-trading-under-mifid-ii/.