To best understand the many factors influencing and impacting upon dark trading, it is necessary to identify with the history behind how it became an established method of exchanging risk in bulk. The early dark pools in the 1980s originated in the United States in response to institutional investors who wanted to trade anonymously to prevent information about their large block orders from leaking into the market. As algorithmic trading became more common, order sizes were driven down and it became harder to execute larger order sizes without moving the market. Institutional investors also wanted to reduce transaction costs.
The first emergence of “dark” liquidity came with the fruition of iceberg orders, which were displayed on the “lit” exchange order book. Iceberg orders withheld the true size of larger orders, and became an important tool for institutional investors looking to realise efficiencies. The earliest dark pools (electronic crossing networks, or ECNs) were set up solely to solve the problem of getting bigger deals done immediately and anonymously and without moving the market price. There on in, a status quo evolved between lit and dark liquidity, with each providing an optimal execution method for different types of business: traditional exchanges facilitating lit trading where orders and pricing information is viewed pre-order, and non-displayed liquidity pools offering liquidity for block trading with no indication of market depth pre-order.
The US saw trading volumes rise steadily as non-displayed liquidity became an established and accepted market function for trading large blocks of stock. Following the rise of dark liquidity in the US, Europe too has started to see growing volumes traded in the dark.
Concentration rules across the major continental centres, removed by legislative changes, previously restricted trading activity taking place away from the home market. The advent of the European Commission’s (EC’s) Financial Services Action Plan (FSAP) and its cornerstone Markets in Financial Instruments Directive (MiFID), the European Union (EU) law aimed at harmonising regulation for investment services across member states, represented a key moment in the evolution of dark trading across Europe.
The way business is executed has since changed with an increasingly diverse range of participants driving competition and generating efficiencies for the end client. MiFID effectively removed concentration rules that drove trading to the home markets, and this liberalisation, combined with a huge growth in volumes, technological advancements and a dramatic reduction in order size on the lit market, paved the way for a revolution in the trading landscape. We have since seen successful competition in the form of a number of multilateral trading facilities (MTFs), and exchanges, MTFs and brokers are also launching their own dark pool platforms.
Not all dark pools are equal
In capitalising on this environment, dark pools have therefore started to gain traction, and today there are more than 20 in Europe. However, not all dark pools are equal or seek to achieve the same goal, and it is important to note the existence of the many different platforms and how they vary greatly in character and make-up. Buy side only pools, are exclusively open to the buy side, and match institutional buyers and sellers.
Exchange/MTF sponsored dark pools—of which many examples have sprung up over the past 18 months in Europe—generally provide interaction between dark and in some cases visible books, for sell side intermediaries of which SmartPool is one. There are also broker dark pools which are designed primarily to internalise the operator’s trade flow. These differ from public crossing networks in that they can contain the operator’s proprietary flow beyond just that from their institutional customers. Lastly, the independent and consortia dark pools (unlike those backed by a single broker) are operated by numerous partnering brokers and independent operators.
The growth in lit and dark offerings from all sides has caused the boundaries between the activities that define an exchange, MTF and broker crossing network to become blurred. At the same time it has become increasingly apparent that the current regulatory framework, as defined by MiFID, can be improved upon in its application across trading venues to bring greater transparency to this new environment. The core aims of MiFID are clearly identifiable; to promote competition between trading venues, to increase investor choice, to lower transaction costs and increase efficiency of the price formation process. Increasing transparency therefore lies at the heart of its existence and the MiFID II review is partly an attempt to redress areas where transparency has been lost due to the unintended consequences of the original MiFID directive.
From a macro point of view it remains complex to assess whether the original objectives of MiFID have been met, in particular within the context of the massive unpredicted market shifts and volatile trading conditions caused by the recent downturn. History teaches us that we tend to overestimate the effect of change in the short term and underestimate its effect in the long term. What is key in the implementation of further regulation is that the heterogeneous nature of the market is further encouraged. There is a natural tension in any marketplace between those who would prefer increased transparency and those who would prefer less, however the impact of MiFID has been broadly positive for both the market and end investor thus far.
Even so, a number of enhancements to the regulatory framework can be made, particularly around the area of market transparency. Firstly, the adoption of specific guidelines and standards for post-trade publication would ensure greater consistency of reporting and granularity of data, enabling users to better interpret and analyse trading activity. At the same time it is widely recognised that a harmonisation of pre-trade transparency waivers is required so that a clear distinction can be made between the risk business carried out by intermediaries in the normal course of their business, and basic crossing functionality. While this is being addressed by MiFID II, the challenge for regulators is to ensure that innovation and competition, which are ultimately of benefit to the end user, remain and flourish.
A level playing field
The third factor to be considered is the creation of a level playing field for like-for-like activity. It is widely accepted that the trading of stocks away from a central marketplace meets the legitimate needs of market users, and as such the existence of broker dealers operating crossing networks is a welcome presence. Investment banks committing capital to clients and facilitating their trading needs is a legitimate business practice that has been held as a basic principle of public markets since trading began. Regulation has been good for the market to date and the future of dark trading remains bright, not least because the ability to execute in size at improved execution prices offers a fantastic value proposition.
As trade sizes continue to reduce on the lit markets and high-frequency trading and algorithmic strategies persist unabated, the demand for high-quality execution services remains high. One size no longer fits all, and dark pools offer institutional investors, often working on behalf of collective vehicles representing retail investors, many of the efficiencies of public limit order books without revealing their intentions to the public market. While we are unlikely to see a wholesale shift from public limit order books to dark trading venues, dark venues will begin to encourage greater levels of block trading as the value proposition helps to unlock greater levels of liquidity directly from the buy side to execution venues.
The route to efficient block trading in Europe is through scale and community, more so than ever in an environment where it is becoming increasingly apparent that only the strongest will survive. The ability to leverage a global client base with a single point of connectivity for all European cash market services delivers the ultimate trading experience. Much as supermarkets are now able to reach out to their customers via their iPhones, allowing them to select an application to order their groceries online, a broad base of customers using a common technology platform is a must when looking to achieving scale.
By means of NYSE Euronext’s Universal Trading Platform, our European cash customers can access the regulated markets, NYSE Arca Europe and SmartPool via the same gateways, protocols and market data platform on the same matching engine. Extending the range of applications that a community of users of a particular platform can access without re-engineering is not a new concept; but it is a powerful one. This example shows how the key barriers of inaccessibility and inertia are removed by allowing customers to access new services via an existing, global and scalable technology platform. Financial markets operate in a proportionately small ecosphere, and for true scale to be achieved in the dark liquidity landscape, removing barriers to entry and empowering a community of investors to connect to diverse pools of liquidity is vital.
The trading landscape has entered one of the most fascinating episodes in recent years as the full impact of competition and innovation plays out before us. At the same time, traders have evolved into a new breed of faster and smarter operator, and embracing dark trading in Europe is the next logical step as they look to deliver value to the end investor in a market where executing large blocks of stock remains a challenge.
Connectivity to the communities that matter holds the key to exploiting the scale, breadth and depth of the European trading market, and is one of the most important drivers in establishing a sustainable future for dark trading. SmartPool has the unique advantage of being able to draw on the broadest and deepest liquidity base in Europe with access to a client distribution network of more than 220 firms, both large and small, committing active order flow. We look forward to the opportunities of a marketplace where one size no longer fits all.