10.30.2014
By Terry Flanagan

Dark Pools Need to Add Value

Seth Merrin, founder and chief executive of Liquidnet Holdings, the block trading platform said regulators should ensure that dark pools provide value above exchanges in either size or price.

Merrin spoke on the Future of Trading panel at the Milken Institute London Summit on October 28. He said dark pools were originally set up to allow institutions to trade large blocks but many now have average trade sizes which are smaller than on exchanges.

“Australia, Canada and Europe have said it and the SEC has proposed that dark pools should provide value in either price improvement or size,” he added. “If they cannot, then trading should be on exchanges so the price discovery mechanism remains sacrosanct.”

Adena Friedman, president, global corporate, information & technology solutions, at Nasdaq was also on the panel and said that Reg NMS, which changed equity market structure in the US, had been created to ensure that trades in dark pools were of larger size or at improved prices. “Dark venues need to add value but how do we prove that ? The US uses prescriptive rules while Europe is more principal-based,” she added.

Barb McKenzie, senior executive director and chief operating officer, boutique operations, at Principal Global Investors said institutions need their own trading lanes, similar to the lanes on roads for higher speed traffic. “I don’t care whether we trade in the dark or the light but still need a venue where we can get a large trade done and get a good price,” she added.

Merrin agreed that equities should have a wholesale institutional market. “Every other market has a wholesale market with wholesale buyers and suppliers which creates depth,” he said. “Retail can then come to them and the overall marketplace is better.”

He added that European regulators are proposing some progressive rules such as the large-in-scale waiver to avoid caps on dark pool trading and the full disclosure of fund management fees, which will benefit the end investor.

Mark Hemsley, chief executive of Bats Chi-X Europe said on the panel that Europe needs a consolidated tape to provide a reference point for best execution and allow investors to easily research a company’s trading history.

“A consolidated tape would allow pan-European regulation to be more cost effective as a special version could easily be produced for regulators,” said Hemsley. “The Flash Crash showed that markets need limit up and limit down stops in high volatility and there needs to be a common reference point. A consolidated tape is a key piece of market infrastructure.”

Moderator Jamil Nazarali, senior managing director and head of Citadel execution services at Citadel Securities, asked panellists what would be the next big disruption.

Merrin suggested fixed income. He said: “Fixed income needs to be disrupted because there is a disaster waiting to happen.”

This year Liquidnet entered the fixed income market through acquiring bond trading platform Vega-Chi.

Quantitative easing has kept interest rates artificially low and investors have poured money into bonds. “If rates rise slightly investors will start seeing losses and everyone will be moving toward the exits after the doors have closed,” Merrin added. “Fixed income has traditionally been a dealer facilitated market and we are entering a phase where fixed income will need more dealer capital and places to find liquidity.”

McKenzie argued: “We need capital but this does not necessarily need to come from dealers. We need a new source of capital but who could be attracted to come in ?”

Friedman said Trace, the US corporate bond reporting system, had helped improve liquidity by publicly reporting all trades after certain periods of time. “Regulators are now looking at pre-trade data from new electronic venues and whether that should be forced into the public eye,” she added.

Hemsley said there is a lack of visibility on over-the-counter trading in Europe. “We have made an enormous effort over the last two years to process OTC trade reporting and provide facilities so these trades can be brought onto an exchange and cleared,” he said.

He also mentioned that front office trading venues need to change. “We need a whole new range of venues for trading different instruments at different times,for example, small-cap equities or illiquid fixed income.”

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