Reassessing Dark Pools

Terry Flanagan

Scrutiny on equity-trading venues that are out of the ‘light’ of public exchanges is ratcheting up in the wake of allegations that a prominent Wall Street dark pool gave preferential treatment to high-frequency traders while downplaying their presence in marketing materials.

The June 25 lawsuit filed by New York Attorney General Eric Schneiderman against Barclays raises questions about the future of its LX dark pool, but market participants and operators note that in a broad sense, the utility of the trading venues will endure.

Dark pools’ raison d’être is to allow traders of large blocks of stock to transact in a way that minimizes ‘leakage’ of information regarding buying and selling interest, and thus enables more efficient trading. Some observers note the ‘dark pool’ name is unfortunate in that it implies nefarious activity may be occurring out of view, but if operated properly and above-board, the trading venues can protect investment returns of end-user investors such as pension-plan retirees.

One vital characteristic for dark pools is differentiation from exchanges.

Adam Sussman, Liquidnet

Adam Sussman, Liquidnet

“If you’re a dark pool, you should be delivering a benefit to the rest of the market,” said Adam Sussman, head of market structure and liquidity partnerships at Liquidnet. “Are you treating all clients equally, are you marketing accurately, and are you delivering benefit to the market and not just mimicking stock exchanges?”

According to press accounts, some market participants stopped routing orders to Barclays LX after the lawsuit was announced. Beyond anecdotal reports, the market is awaiting the next batch of Alternative Trading System data as reported by Financial Industry Regulatory Authority for a more definitive assessment on the impact on dark pools. For the short term, it is expected that at least some momentum, in the form of order flow, has moved toward ‘lit’ exchanges.

“There have been continued questions as to where orders are being routed and where people are interacting, and in some cases instructions to stop routing to venues where folks no longer feel comfortable,” Sussman told Markets Media. “When news like that comes out people pause, reassess the relationship, and then as more facts become available they decide about the long-term relationship.”

Dark-pool reviews are mostly happening at buy-side and mid-tier sell-side firms, noted Nitin Gambhir, chief executive of Tethys Technology.

“If the buy side is using broker algos, they are now requesting real-time information on each fill as to where the order was executed,” said Gambhir. “They want to know the exact destination of every fill.”

Some market participants are looking at alternatives to private dark pools, one of which is a dark-pool-like trading experience on an exchange.

“‘Public dark’ is basically using hidden order types and dark order types on exchanges,” Gambhir said. “The advantages of doing that are that you’re in a regulated marketplace where the order priority and order types are disclosed have been approved by the SEC, versus dark pools where you may not know what the rules really are.”

Dark pools are challenged but the current situation can prove constructive over the longer term, provided the industry makes changes.

“For dark pools to survive and thrive in the long term, they need a standard set of rules that makes them look like exchanges in terms of order handling,” Gambhir said. “I expect a scramble by dark pool operators to standardize — essentially request the SEC or Finra to put in rules. If that happens, the question becomes what are the advantages of dark pools, and it will come down to price.”

Liquidnet’s Sussman advocates HFT-free ‘zones’, as well as midpoint execution, larger trade sizes, and more transparency.

“One of the things we’ve done, and we hope that the rest of the industry follows suit, is issue clear and frequent updates to all members about the operations of our trading venue,” Sussman said. “This includes going over and above just making that information available, and  allowing members and clients to opt in to any kind of liquidity that they deem fit.”

Featured image via NAN/Dollar Photo Club

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