Rather than increase transparency, the latest proposals to restrict dark trading at four and eight per cent have the potential to create greater opacity as well as seriously impact institutional investors’ ability to execute order flow.
Drawing on new research from TABB Group Europe, 86 per cent of investors say they have serious concerns regarding the introduction of volume cap proposals with the vast majority anticipate being forced to return to more traditional forms of execution.
According to TABB’s senior research analyst Rebecca Healey in London, who wrote “European Dark Trading: A Question of Clarity,” the recent decline in trading activity from bilateral over-the-counter trading versus the increase in automated dark venues has enabled traders to become more autonomous from brokers in their endeavours to maximise returns for investors. The increased usage of FIX Protocol tagging, venue analysis and TCA allow greater post-trade transparency, which provides the correct level of pre-trade transparency without negatively impacting the institutional trader in the process.
“Ultimately, this offers the buy side improved choice in venue selection,” she says.
Dark trading has always existed, says Healey, explaining that the difference now is that rather than the buy side turning de facto to the sell side to execute a block on their behalf, they are choosing to take control of their order flow – when, where and how it is executed.
“As such, 98 per cent of institutional investors tell us that they now prefer to access alternative liquidity pools in their hunt for anonymity and reduced market impact,” says Healey.
However, the ability to reduce the signalling of trading intentions has been compounded by an overall decline of European trading volumes by 49 per cent since 2008.
“Combine this with a reduction in available risk capital for the majority of European buy-side participants,” says Healey, “and it’s easy to see why protection, liquidity and price improvement institutional investors find in the dark are hard to ignore.”
As trading becomes further divorced from the research process, proving best execution has been delivered will be critical. Full disclosure of execution, dark or lit, will become mandatory.
Healey says: “Regulation would achieve greater transparency by 'cleaning up' dark trading, clarifying the rules within an appropriate framework to maintain choice for the benefit of the underlying investor, rather than obliterating dark pools in their entirety. Frankly, now is the time for dark trading to come clean. It’s really a question of clarity."
To that point, TABB recommends four positive steps be taken now to deliver greater transparency without impacting liquidity formation, prior to the implementation of any volume cap on the dark:
• Improved harmonisation of data standards and greater mandated reporting to increase robust monitoring and enable more effective supervision.
• The retention of the equity OTF category.
• Meaningful price improvement should be required, which would require execution of any order benefiting from the waiver at the midpoint between the best bid and offer.
• Allow the ability to adapt and react as regulations come into force.