Dark pools braced for uncharted waters

Dark pools are not the “new black” anymore – they have been in Europe for more than a decade – but recently these esoteric trading systems emerged as the new battleground for European exchanges and their ambitious rivals.
Multilateral trading facility Turquoise signed up six customers to a new service that aggregates the liquidity in their dark pools while a rival MTF, Bats Europe, detailed its plan to launch a dark pool.

Separately, the LSE launched its dark pool Baikal, offering its members the ability to route orders to other trading platforms, and affirmed its commitment to support dark pool trading “later this year” though it declined to be more specific.

The challenge for these providers – as with every trading entrant – is to attract from day one the liquidity that compels firms to start using the system. But these ventures face the added problem of launching into a competitive market where exchanges (NYSE Euronext), MTFs (Chi-X Europe and Turquoise), banks (all the big names) and brokers (Instinet, ITG, Liquidnet and Nyfix) are already fighting to win a critical mass of liquidity despite relatively slow trading.

The recent launches also came at a time of uncertainty about how dark pools fit with US and European authorities’ pledge to ensure transparent markets.

UK financial watchdog the FSA set out guidelines on reporting bilateral trades at a meeting with market participants, according to a source close to the matter.

Furthermore, the sudden proliferation of dark pools has fuelled concerns among buyside dealers that it is becoming harder to find liquidity, something that is hampering their ability to trade effectively.

Systematic philosophy
However, Mike Seigne, the head of algorithmic trading at Goldman Sachs, which has one of the largest dark pools in the US and a fast-growing European offering, argued that dark pools had been misrepresented.

He said: “There is nothing sinister about dark pools, rather they are trying to solve a real requirement on behalf of the clients. The trend of average trade sizes on the lit venues in Europe has continued to decline. This has created a need to try to reaggregate some of these orders into more meaningful liquidity opportunities. Dark pools are simply addressing this need.”

Lee Hodgkinson, the chief executive of NYSE Euronext’s SmartPool, the exchange’s dark pool that launched in February, said dark pools were necessary because the average trade size on the main European exchanges has dropped below €10,000 for the first time, meaning firms are struggling to find on these systems liquidity in what traders call “size”. But Hodgkinson is philosophical about the increased regulatory scrutiny that has been brought to bear on dark pools, arguing it is prudent to test the systems that have emerged after the November 1, 2007 introduction of the European Commission’s Mifid rules.

He believes the review should focus on all market participants that provide dark pools, but said the exchanges and MTFs are obliged to meet stricter regulatory requirements than the banks though they all provide similar services.

He said: “This complex review will cover a range of topics as well as dark pools including the systematic internaliser regime which may need to be reworked. There are currently different regulatory treatments in place for dark pools across the exchanges, MTFs and brokers, though they provide largely the same services to the same customers. We need to encourage a level playing field.”

Seigne fears an overzealous push to transparency by regulators will limit dark pools’ ability to function and hurt traders.

He said: “It is important to remember that at some point too much transparency can become detrimental to a client’s execution quality, particularly if the client is trying to execute a large order.”

A more immediate concern that can be traced to the rise of European dark pools is the increasing fragmentation of liquidity, leading to confusion among traders as to the sources of liquidity.

Most of the dark pool suppliers have seen this and, in the spirit of turning a problem into an opportunity, they are looking to provide additional services to tackle this new requirement.

Goldman Sachs, Morgan Stanley and UBS struck a deal two months ago to link their dark pools and offer European clients access to three of the biggest bank dark pools.

But rivals, such as Bank of America Merrill Lynch, have taken a different approach and signed up to allow bank consortium-owned Turquoise to manage the aggregation.

The US bank, CA Cheuvreux, Citadel Securities, Citigroup, Deutsche Bank and Nomura International last week became the first six groups to sign up to the MTF’s aggregation service.

Yvonne Hansmann, head of Emea execution sales at Bank of America Merrill Lynch, said: “We spoke to the buyside and they gave us a strong indication that this type of aggregated service is the way forward.”

Her colleague Brian Schwieger, head of Emea algorithmic execution at Bank of America Merrill Lynch, added: “The advantage of Turquoise is that it limits the signalling associated with the bilateral broker model. The multilateral model, incorporating six brokers, ensures the Turquoise pool and brokers’ participation stay completely dark.”

The LSE is also bidding to help customers with their aggregation issues and its chief executive Xavier Rolet said: “We have delivered the first part of Baikal’s solution for aggregating liquidity and solving the challenges of market fragmentation.

“We look forward to building on this important milestone with the launch of the non-display order book and further liquidity aggregation services later in the year.”

Dark pools are a fine idea in principle and their providers are moving quickly to address the problem of fragmentation, but the reality is these trading systems have actually created unforeseen problems for many customers, at least in the short term.

How the ‘hidden equity market’ operates

What is a dark pool?
A dark pool is an electronic equity system that differs from an exchange order book by hiding attributes of an order, such as the price or the identity of the broker.

Who provides these systems?

Agency brokers ITG and Liquidnet were the first to launch in Europe, but in the past two years every investment bank worthy of the name has been building and marketing its European dark pool. More recently US brokers, such as Instinet, Liquidnet and Nyfix, and Europe’s stock exchanges have got in on the act with NYSE Euronext launching its Smartpool in March and the London Stock Exchange opening its Baikal system in July.

Why are they important?

Buyside dealers and sellside traders have long complained the exchange order book, the standard mechanism for European share trading, gives up to the market at large vital information about an order. This is less of an issue for normal-sized orders, but this transparency can be problematic when a trader is looking to execute a large block of shares or an order in an illiquid stock because rivals can see what is happening and trade against, or “front-run”, the order, which can prove costly.

What is the downside?

Regulators are suspicious of dark pools for the very reason traders like them – their opacity. European regulatory body the Committee of European Securities Regulators has been peering into the dark this year while the UK’s Financial Services Authority clamped down on some dark pools earlier this year, forcing them to change how they generated prices. The emergence of numerous dark pools has also confused traders because there is no way of knowing which pools have liquidity in a certain stock. Trading firms have to “sweep” each dark pool separately, which can waste time, a problem some firms are looking to tackle by “aggregating” dark liquidity on behalf of their customers.


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