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Volumes grow but will regulation dampen spirits?

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By James Williams – Dark pools exist in a variety of forms to serve a variety of clients. In the US they are referred to as an alternative trading system (ATS). In Europe they include multilateral trading facilities (MTFs) – alternative trading venues that sprang out of MiFID regulation in 2007 – broker-owned pools called Broker Crossing Networks (BCNs) or “internalisers”. Not to mention independent dark pool operators like Liquidnet that connect buy-side to buy-side institutions.

The number of dark pool venues that now exist has risen considerably: it is estimated that there are some 45 such venues in the US alone.

As their numbers grow, so, it seems, does their popularity.

A survey by the CFA Institute found that the trading of US equities on dark pools had risen 48 per cent since 2009. Today, it is estimated that trading in these venues accounts for roughly 12 per cent of total trade volume in the US compared to 4 per cent in 2008, according to Rosenblatt Securities, an agency-only execution boutique. Specifically, Rosenblatt reported dark pool market share of 14.26 per cent in March and 14.67 per cent in April.

On the 31 March 2013, the New York Times reported that the portion of all stock trading taking place off-exchange had, that month, hit new highs, amounting to close to 40 per cent on several days. To clarify, however, this figure encompasses venues that previously operated as ATS but which are now licensed exchanges (e.g. BATS, Direct Edge) and as such are required to report to Trade Reporting Facilities.

“At the beginning of the year it was around 36 to 37 per cent. Since then it has backed off a little bit but we’re still at more than double where we were five years ago,” says Justin Schack, managing director, Rosenblatt Securities.

Société Générale launched its dark pool, AlphaY, in April 2012, and is already amongst the largest broker-owned off-exchange venues in Europe. “Considering we’ve avoided doing anything that generates liquidity like market making it’s enabled us to become meaningful in terms of size but still retain a high quality liquidity profile that prompted us to launch AlphaY in the first place,” explains Mark Goodman, head of quantitative electronic services.

One factor that has contributed to increased usage of dark pools has been a rebound in equity markets in 2013. Benign market conditions and lower volatility means that institutional traders are more comfortable resting their orders in the dark. Goodman suggests that there is an inverse correlation between volatility and dark pool market share: “The higher the volatility the more aggressive they are about getting orders filled. Dark pool market share will generally fall during volatile markets.”

Schack shares a similar opinion: “In 2008 when the VIX index spiked up there was a disincentive to use dark pools. Since mid-2009, VIX has been on a steady march down, with the exception of a few unsustainable spikes, and is now in the low to mid teens. That has encouraged traders to direct flow away from the exchanges.”

BATS Chi-X Europe is an MTF. The difference between an MTF and a BCN is essentially client discretion; whereas a broker-owned pool can decide who can and cannot participate, an MTF has no discretionary control and is often termed “exchange-lite” as all buyers and sellers are welcome.

BATS Chi-X Europe runs two displayed (lit) order books and two non-displayed (dark) order books. As of 30 May 2013, its lit order books accounted for 24.11 per cent of the market, compared to just 2.08 per cent for its dark books. Across pan-European venues, these figures were 93.82 per cent and 6.18 per cent respectively.

Even though the dark order flow at BATS Chi-X is relatively small, “our data suggests that there has been a slight increase in dark order book trading in Europe this year”, confirms a spokesperson.

Specifically, between January 2012 and January 2013, dark order book market share climbed from 1.42 per cent to 1.77 per cent. Between March 2012 and March 2013 those figures climbed from 1.15 per cent to 1.63 per cent.

Bill White is head of equities electronic trading at Barclays Capital in New York. In his view, the fact that there are now more pools to choose from – including Barclays LX, which launched in EMEA just over two years ago – and people are getting better at executing orders and accessing these pools, means that dark pool growth is understandable.

“We have seen activity increase consecutively month on month as our liquidity aggregation on the platform has improved. We’ve invested heavily in the latency component, but it’s also thanks to how our router works and the toxicity framework that we have in place. As a result, our client base has become comfortable with how we manage liquidity in the dark venue,” says White.

What seems to be helping clients who use Barclays LX is that, even though it is a dark venue, the level of transparency offered is actually quite significant. “We show them, real-time, where we are executing orders, what the execution profile is for each order etc,” adds White.

According to the TABB rankings in April 2012, Barclays LX ranked number four behind Credit Suisse, Goldman Sachs and Knight Capital, trading 78million shares a day. By April 2013, it held the number one position, trading 99million shares a day.

Adds White: “We understand what execution quality and information protection means. Introducing a stable router, a low latency platform with control over liquidity profiling: all of the enhancements we’ve made over the last two years help to explain why LX has enjoyed consistent growth in the market.”

In Europe, Deutsche Bank’s own BCN, SuperX, which launched in 2010, has likewise enjoyed volume growth.

“If the liquidity experience of clients is positive they’ll come back so it creates a snowball effect and that’s really what we’ve seen over the last few years,” explains Andrew Morgan, co-head equity trading EMEA at Deutsche Bank.

“Our dark pool market share has benefited as a result of recent investment in the technology as compared to some of our peers. In Q4 2012, we were the number two dark pool in Europe according to Rosenblatt. Volumes have been slightly impacted this year because we switched off our crossing capability into Italy, while uncertainty surrounded implications of the transaction tax, but we have since switched it back on.”

Between April 2012 and April 2013 the pool saw a EUR2.1billion or 15 per cent increase in volume, which shows the extent to which buy-side institutions are interacting with these dark venues. According to Morgan, the average fill size, during that same period, increased by “50 per cent”.

Another possible driver of increased activity in dark pools relates to execution fees that brokers have to pay for routing orders to the exchanges. In a nutshell, avoiding interaction with the primary market reduces costs.

“Their access fee cap is 30 cents per 100 shares under Reg NMS and a lot of the exchanges are close to, if not at, that level. Brokers therefore have an incentive to divert flow away from the exchanges to lower cost venues, many of which happen to be dark pools,” observes Schack.

“The other issue is customer segmentation. In the US, exchanges operate under the principal of fair access, meaning that they have to offer the same terms and access to their liquidity to everybody. An ATS does not have to do that. It can stipulate who interacts with who, and offers clients customised experiences.

“I’d say these are two of the biggest reasons behind the growth of dark pools in recent years.”

Anthony Godonis is senior equity trader at Aberdeen Asset Management. He notes: “Commission rates have fallen in recent years so there’s less margin available, even for the agency-only brokers. The bigger exchanges have such a high cost structure to execute that there’s no incentive to use them when the brokers can execute internally on the dark pool more cheaply.”

Platforms like AlphaY are not only giving clients the opportunity to interact with high quality liquidity – hedging flow from its derivatives and Delta One business – but the ability to benefit from liquidity profiling. This is achieved by measuring the quality of liquidity in other dark venues that AlphaY interacts with, creating a liquidity spectrum that ranks the toxicity of liquidity.

As a result, buy-side clients are able to develop a more nuanced appreciation of how to trade in the dark. Rather than reduce their liquidity options by saying ‘I don’t want to interact with ‘X’ venue because of toxicity issues’, they are, in Goodman’s words, better able to recognise the fact that “all liquidity is useful some of the time but not all liquidity is useful all of the time”.

“If you’re able to measure that type of liquidity, then when you’re making trading decisions you can decide to use or not use venues on that particular basis. It means you don’t take a black and white view of things by cutting certain dark pool venues and sticking to others.”

Another reason why dark pools have blossomed in recent times is thanks to better technology, in particular dynamic smart order routers.

“A range of information is fed into our router, which then says, ‘At this given point in this name, because possibly there’s no liquidity, the best way is to post a bid on a public venue. Or maybe the profile is very liquid, there’s a lot of turnover, so let’s post at mid-point in the dark pool’. The router utilises its own dynamic decision process. LX is just another input to it,” explains White.

Deutsche Bank’s most popular algorithm with clients is Stealth, says Morgan.

“It opportunistically leverages the dark venue. When you send an order to Stealth, unless you’re using it in very specific circumstances it will typically rest your entire order in the dark pool with a view to getting it filled subject to a minimum fill quantity.

“It’s about getting access to the right liquidity at the right time, and, importantly, at the right price.”

Even though dark pools are growing in popularity, and trading volume, regulation is lurking in the distance, which could potentially restrict the way these dark pools operate.

With average trade order sizes falling, the operators of primary exchanges are getting increasingly vocal. Their concern is that dark pools are not necessarily offering significant price improvement. A joint proposal by the SEC and the CFTC Advisory Committee is the “trade-at rule”.

This would basically force alternative venues to post displayed limit orders and provide more transparent price discovery. Any venue not displaying the National Best Bid and Offer (NBBO) would either have to execute the order with significant price improvement or else route the order elsewhere i.e. the lit market.

In Europe, regulators are now proposing a “volume cap mechanism” on off-exchange venues under the Markets in Financial Instruments Regulation. This would place a 5 per cent trading limit on every instrument traded on a dark pool. This is far from ideal for institutions who still rely on the ability to execute block trades safely and anonymously. After all, the very assets being managed by these institutions are peoples’ hard-earned pension funds.

Lee Hodgkinson is Head of Sales & Client Coverage EMEA and APAC, at NYSE Euronext. His view is that, far from being against dark pools, all the exchanges want to see is a more level playing field from a regulation perspective.

“We accept that one size no longer fits all and that there need to be alternative trading venues to meet the needs of a wide range of modern investors. It’s incorrect when people characterise us as being de facto opposed to dark pools as we are not.

“However, we do think that more oversight and transparency is needed. Dark pools and internalisers now have, on both side of the Atlantic, a competitive advantage which is obtained without contributing to price discovery.

“MiFID II, in our view, should level the playing field with respect to the regulatory obligations that trading venues need to adhere to – with certain provisions for the wholesale market – and also to improve transparency. Not because of the competitive dynamic, but primarily for investor protection,” says Hodgkinson.

“This has had an impact on the profitability of exchanges, their market share has dropped, so they are understandably fighting their corner,” says Morgan.

“The price improvement aspect of dark pool trading isn’t just about the price that you trade at now. What’s more of a feature is the ability to manage that impact thereafter. If you’re trading opportunistically within the dark pool you can still manage your price impact over the duration of an order more efficiently than you would were you to leave a footprint on the lit market.”

Hodgkinson is clear to caveat his position with respect to the wholesale market, agreeing that block trades that could potentially move the market still need to be handled in an appropriate framework.

The bigger issue goes back to the point that many dark pools are executing smaller orders – retail flow – without transparency.

“The spirit of MiFID never intended retail transactions to be handled in private networks. We believe that there should be a limit to the transparency protection that is applied to orders. Otherwise, you’ll get to the point where nothing gets done in transparent and open markets.

“Without the retail definition in MiFID, size is the only proxy you can have,” says Hodgkinson.

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