Ask the experts: Dark pools

Barclays and Goldman Sachs were sued recently over their use of ‘dark pools’, but what are dark pools and why are regulators targeting them? Siobhain Egan, Director at Lewis Nedas Law, explains all

What are dark pools?Dark pools are electronic Alternative Trading Systems, similar to stock exchanges, where trades can be matched. The main difference is that in dark pools, the price at which shares are offered for sale cannot be seen by anyone – even those participating in the exchange. The price at which shares change hands is only disclosed after the Siobhain Egan, Lewis Nedas Lawtrade is completed. This limits the amount of interaction between participants as they do not know when to move their price up or down in answer to the trade.

Although the term ‘dark pools’ is relatively new, the practice has been around since trading began and was previously called 'upstairs trading'. They are not a ‘black market’ trading platform. The prices and size of trades are just not displayed. A dark pool allows traders to buy or sell large amounts or 'blocks' without other traders knowing that the sale is being made. This prevents other traders from putting the price up or down and minimises the block trade's effect on the market.

Why have dark pools become increasingly popular with traders?Dark pools have become more widely used due to technological advancements that have lowered costs, allowing brokers and dealers to route more of the order flow they handle to their own private pools first, before sending unwanted orders to the public markets.

Shot in the dark?
The second Markets in Financial Instruments Directive (MiFID II) will place limits on dark pool trading throughout Europe.

The first limit caps dark trading in any stock at 4% on a single venue, while the second places an 8% limit on dark trading in that stock on an EU-wide basis.

If the 4% limit is breached, dark trading will be banned in the affected stock on that specific venue for six months. If the 8% level is breached, dark trading in the stock will be banned EU-wide for six months. The caps are based on the total volume of trading in a financial instrument on all trading venues over the previous 12

Some industry experts, however, have warned that regulators face a tough challenge to collect and analyse the data they need to police the new rules on dark
trading under MiFID II.

The Directive, which aims to establish a safer, more transparent and more responsible financial system across the EU, is not expected to come into force until 2016 or even 2017.

Dark pools are not damaging to the stock market. The US Securities and Exchange Commission (SEC) has recognised the importance of institutions being able to work orders without displaying the whole order “to maintain long-term confidence” in the markets. Dark pools are highly regulated. All dark pools are registered with the SEC and the Financial Industry Regulatory Authority (FINRA), and are subject to regular audits and examinations.

They are not environments where the participants 'go in blind’. Participants choose to place their orders in a dark pool. The users are sophisticated traders who understand the advantages of not displaying their orders at an exchange. Dark pool prices are not just made up, either. Trades are bound by the National Best Bid and Offer (NBBO) and prices cannot be chosen arbitrarily.

The volume of trade in dark pools is increasing because the system really works for institutions. The percentage of non-exchange trades has grown to roughly 33% of all trades, up from no more than 10% a decade ago. The likely reason for this growth is that users have had a better experience and more success using dark pools than they have had using regular exchanges.

Dark pools are not all the same. They have varying features to appeal to different segments of the market. Some only allow certain types of traders while others allow participants to rank trading partners and opt out of those they do not want to trade with. The main purpose of dark pools is to minimise market impact. By restricting access to undesirable market participants – for example, high-frequency trading firms – and by not revealing prices, dark pools enable institutional investors to minimise their information disclosure and execute trades more efficiently.

More precisely, dark pools create the possibility of price improvement and lower transaction costs by crossing orders at the midpoint of the quoted NBBO prices, which saves on both the bid-offer spread and exchange fees.

Why are governments worldwide considering tighter regulation of dark pools?Dark pools have been criticised for their lack of transparency and their potential to cause fragmentation, which can lead to less efficient pricing. This has led to growing calls for greater transparency of trading venues. It has also potentially opened up dark pool operators to wider legal action from government agencies.

In the US last year, the Chief Executives of NYSE Euronext, Nasdaq OMX and BATS Global Markets urged regulators to introduce rules permitting trades to only take place away from a public exchange if a customer is getting an improved price. These exchanges referred to steps taken by Canadian and Australian regulators to fight the rise of dark pools.

There may now be a greater incentive to increase regulation of dark pools in the UK following legal action taken against Goldman Sachs and Barclays in the US. Goldman Sachs was fined $800,000 by FINRA for failing to ensure that trades executed in their dark pool were being made at the best price, while New York State filed a lawsuit against Barclays relating to high-frequency trading in its dark pool. 

The fine and lawsuit follows the SEC’s announcement that it would review the transparency rules regarding dark pools in a bid to make them more open. Due to increased criticism and legal activity, some dark pools have in recent months voluntarily published information on how they operate. We can expect further light to be shed on dark pools in the months and years ahead.
About the expertSiobhain Egan is a Director at Lewis Nedas Law, a leading corporate crime law firm based in London. She has more than 24 years’ experience as a solicitor, specialising in areas including financial crime, regulatory defence, compliance and business investigations.
Published: 17 Jul 2014
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