Shining a Light on Europe’s “Dark Pools”

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Jasper Jorritsma, Marcus Hooper and Frédéric RomandIn recent years, there have been few more topical yet mythicized subjects in institutional finance than high-frequency trading and dark pools. In a session at the fourth annual CFA Institute European Investment Conference in Paris, three experts — Marcus Hooper, CEO of Pipeline Financial Group; Frédéric Romand, Head of Trading at Generali Investments; and Jasper Jorritsma from the European Commission — attempted to de-mystify these subjects by cutting through the complexity of today’s equity market structure.

The backdrop for these structural changes in European equity markets is of course the Markets in Financial Instruments Directive, known by its acronym as MiFID, which was implemented in 2007 but amended only two weeks ago after a year-long review process.

To tackle this timely subject, the panel discussion began with a debate on the new “Organised Trading Facility” (OTF) trading venue classification under MiFID. Jorritsma explained that the Commission had created the OTF category as a means to ensure that all systematized trading is captured under the MiFID framework, an objective that stems from the G20 mandate to ensure that as much trading as possible takes place on regulated electronic marketplaces. But according to Jorritsma, broker crossing systems — the “dark pools” of liquidity run by banks – would not be able to combine the crossing of client orders with bilateral execution against the broker’s own account under the OTF framework.

Generali Investments’ Romand noted that, practically speaking, dark pools have been around for more than 20 years in one form or another. Today’s electronic incarnations are just more technologically efficient ways for buy-side investors to get large block trades executed. There is a legitimate question about how much business is, or should be, executed in dark pools without having a detrimental effect on the price discovery function conducted on the “lit” exchanges — but without better data, it is impossible to tell what this limit is.

Among the panelists there was unanimous agreement on the need for a consolidated tape in Europe to give investors the transparency required to evaluate investment decisions and assess best execution. According to both Romand and Pipeline Financial Group’s Hooper, a consolidated tape is absolutely crucial from the buy side’s perspective. Jorritsma explained that the Commission has opted for a commercially driven approach to developing the consolidated tape under MiFID II. Romand also indicated that post-trade transparency — the public reporting of executed trades — would be very beneficial for other asset classes such as fixed-income and derivatives (another area MiFID II seeks to rectify).

Fourth Annual CFA Institute European Investment ConferenceOne of the most notable micro-structural developments over the past two years, Hooper said, is the steep reduction in order and transaction sizes executed on both public exchanges and dark pools. Hooper believes this is at least partly attributable to the emergence of high-frequency trading and the dominant role it now plays in today’s equity markets. While such trading may bring certain benefits, such as a narrowing of bid-offer spreads, the problem is that high-frequency trading players are speculators only — they have no alignment of interests with long-term investors. Hooper also identified a reduction in market depth, a key gauge of market quality, as being consistent with the growth of high-frequency trading. Lower depth can hurt institutional investors because it makes it harder to get large deals done and increases the market impact costs incurred by larger investors. According to Romand, this is one of the key reasons why the buy-side uses dark pools (which he uses himself for up to 30% of his overall business).

To address some of the problems associated with high-frequency trading, Jorritsma explained that the Commission has proposed a cap on the ratio of orders to transactions in an attempt to limit “quote stuffing” by firms. The Commission has also proposed requiring high-frequency trading firms to provide liquidity on a continuous basis, in part to address some of the fragility associated with volume from high-frequency traders abruptly withdrawing from the market. Hooper agreed this would be appropriate: If high-frequency trading firms call themselves market makers and benefit from market-maker privileges such as the payment of a liquidity rebate by the exchanges, he contended, then they should be required to supply liquidity on a continuous basis.

Whilst Romand agreed that the main thrust of the Commission’s proposals was reasonable, he said that a bigger concern for him was the prevalence of market abuse and the lack of consistent action by the regulators on this issue.

Based on current trends, Hooper soberly concluded that the equity market structure in five years’ time is more likely to be worse off than better off. The message is clear that regulators need to tackle these issues with clarity and speed. MiFID II is certainly a step in the right direction — but only time will tell if it ultimately serves the best interests of all investors.

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