How murky are ‘dark pools’?


Financier Worldwide Magazine

April 2016 Issue

April 2016 Issue

The financial services sector has been no stranger to investigations and sanctions over the last decade. Seemingly not a month goes by without a major bank or financial institution agreeing to settle a case with customers, regulatory bodies, or both, related to some malicious actor or instance of wrongdoing.

Financial institutions have paid out billions of dollars since the onset of the financial crisis and subsequent economic crash to compensate for a wide range of corporate malfeasance, with no end in sight. In early February, the US Securities and Exchange Commission and the New York attorney general fined Barclays and Credit Suisse $154m for their US ‘dark pool’ trading operations, settling both federal and state cases against the banks. According to the regulatory bodies, the banks misled investors and violated securities law in the way they ran their dark pools. The fines bring an end to a high profile lawsuit brought by New York attorney general Eric Schneiderman which began in June 2014 as part of the AG office’s ‘Insider Trading 2.0’ crackdown on electronic trading. Barclays’ fine of $70m is the largest ever levied against a company operating a dark pool.

Though such fines are not sufficient to cripple these financial institutions, the real danger is what they represent. One could argue that the fines send a message that financial institutions must improve the way they operate dark pools, reconsider the types of products they offer to clients, and ensure that those products are what they say they are. Following the settlement of the case, Mr Schneiderman said, “These cases mark the first major victory in the fight against fraud in dark pool trading that began when we first sued Barclays”. He added that “co-ordinated and aggressive government action” had led to “admissions of wrongdoing, and meaningful reforms to protect investors from predatory, high-frequency traders. We will continue to take the fight to those who aim to rig the system and those who look the other way”. Barclays has agreed to split its $70m fine evenly between the SEC and New York State, and the firm has also agreed to appoint an independent monitor to its pool – ‘Barclays LX’.

Credit Suisse has agreed to pay a $60m fine split between the regulators, plus an additional $24.3m in disgorgement to the SEC for executing 117 illegal sub-penny orders out of its dark pool, ‘Crossfinder’. Credit Suisse, according to the settlement, will neither admit nor deny the allegations. “These largest-ever penalties imposed in SEC cases involving two of the largest alternative trading systems show that firms pay a steep price when they mislead subscribers,” says Andrew Ceresney, director of the SEC’s Enforcement Division.

Kept in the dark

Dark pools, despite their ominous sounding name, should be a positive force in the markets. The ‘dark’ element should help parties looking to acquire shares, particularly a considerable number of shares. Dark pools allow for private exchanges for the trading of securities, and are not accessible by the investment public. Their ‘darkness’ refers to their opacity.

The premise behind dark pools is to eliminate the threat of high frequency traders (HFTs) – computer programmes armed with algorithms able to see share orders and complete transactions at breakneck speed – taking advantage of a share order placed by a pension fund or other party. HFTs are able to cheaply acquire the shares desired by other parties as soon as an order becomes public, and make a profit off the acquiring party. By entering a dark pool, investors are able to complete block trades without being ‘preyed upon’ by HFTs. Banks such as Barclays and Credit Suisse establish and market their dark pools in this way, noting that investors will be free from the predatory actions of HFTs, and able to trade freely and securely. To that end, dark pools perform a welcome and necessary function. They allow sophisticated investors to move large blocks of stock without alerting traders. Since their introduction, dark pools have grown in popularity, today accounting for around 15 percent of all trading volume in US markets.

Despite their problems, dark pools have gone from strength to strength.

The introduction of dark pools was supposed to mark the dawning of a new era in which ordinary investors would be protected, but the reality was quite different. ‘Regular’ investors were, it would appear, misled about the nature of who was operating within the dark pools. This created complacency among investors, which was subsequently exploited.

The very structure of dark pools leaves them open to exploitation and impropriety. The cases against Barclays and Credit Suisse alleged that the banks misled investors about the makeup of their dark pools. The HFTs that were supposed to be banned from the pools were present and able to take advantage of their position in the pool.

Dark pools have been a point of contention in financial circles for some time. The publication of a book by Michael Lewis, ‘Flash Boys’, which claimed the stock market is rigged in favour of HFTs, has helped to reignite the debate. But dark pools are still incredibly popular. According to separate studies released by ITG and Liquidnet in January, both of which operate dark pools in Europe, the demand for trading ‘in the dark’ remains strong, up 45 percent by value and 25 percent by volume in December 2015 compared to 2014. The Crossfinder pool, despite Credit Suisse’s involvement in the SEC investigation, has proved to be one of the most popular funds on the market, according to FINRA. Dark pools have proved immune to the affects of the investigation thus far.

Since their introduction, and despite their problems, dark pools have gone from strength to strength. Originally conceived with large institutions in mind in the 1980s, investors of different classes have embraced them. According to Reuters, in 2014 around 40 percent of all US stock trades, including almost all orders from retail investors, occurred ‘off exchange’. In 2008, just 16 percent of trading was done in this way.

Moving forward

Though dark pools have continued to prove popular among investors, there is political will on both sides of the Atlantic to reform the way they operate. The Barclays/Credit Suisse investigation is far from an isolated incident, with other legal cases in both Europe and the US brought against operators for misleading investors. From a European perspective, MiFID II will have a considerable impact on dark pool trading, imposing caps to limit trades, except for those that qualify for the large-in-scale waiver.

Historically, however, progress in creating laws governing HFTs has been laborious and insufficient, which is all the more disconcerting given the level of global trading executed by them. HFTs account for more than half of all equity trading and even more futures trading globally. There are concerns over the ability of regulators to properly govern dark pools. Some believe existing laws have been poorly enforced, and any previous precedents have failed to act as deterrents to malicious parties. Critics argue that more should be done to enhance the scrutiny of HFTs, and that regulators must work harder to identify systemic risks. Though the Barclays/Credit Suisse fines were sizable, it remains to be seen whether they will be effective.

Regulators have been taking action against HTFs for some time. The SEC has collected fines totalling $43.5m since October 2011 relating to dark pools and other forms of alternative trading systems. If dark pools are to be made less ominous for institutional investors, great strides will need to be made, and quickly. Settlements with Barclays and Credit Suisse are a step in the right direction. Yet many investors are sceptical about stepping back into dark pools.

According to a recent report from Greenwich Associates, ‘What Lies Beneath: A Deep Dive Into U.S. Equity Dark Pool Perceptions’, institutional investors, when asked about the pros and cons of dark pools, were more concerned about the negatives. Thirty-five percent of respondents said they avoided particular dark pools due to the risk of exposure to ‘toxic’ order flows, up from 23 percent a year ago. Furthermore, respondents were less inclined to cite specific dark pools as standing out for delivering price improvements. Overall, positive citations fell year-on-year from 30 percent to just 17 percent. “Traders are less likely to accept at face value the quality of execution they receive from dark pools,” says John Colon, managing director of Greenwich Associates.

Given that the ink is still drying on the Barclays and Credit Suisse settlements, buy side traders will no doubt be preparing for continued regulatory scrutiny. The New York Stock Exchange has proposed plans to introduce trading limits to dark pools, plans now under review by the SEC. The proposed rules are believed to be more restrictive than those originally approved by the SEC, as well as rules put forward by rival exchange BATS Global Markets and the Financial Industry Regulatory Authority. But this could create problems. If these different proposals are both approved by the Commission, “member compliance with the differing rules would be virtually impossible”, wrote the Securities Industry and Financial Markets Association in a letter to the SEC in December.

Clearly, there is an appetite to reform the dark pool space, and there has been some limited success elsewhere in this respect. In November, Hong Kong’s Securities and Futures Commission implemented a number of new measures aimed at achieving greater transparency in the industry, and early reports suggest they may be having an effect. Trading volumes in Hong Kong’s dark pools have declined steadily so far in 2016. In February, they generated turnover of just US$2bn, or 1.3 percent of total market volume on the exchange – a record low for the region in absolute terms. The previous record low had been set in December, the first month after the new rules were implemented. In February, dark pool turnover fell 29.4 percent year on year. Institutional investors have cited the regulatory moves made by the Securities and Futures Commission as the main driver behind the decline.

Much like regulators in the US, Hong Kong’s Securities and Futures Commission has also meted out its own financial sanctions to financial institutions. In August 2015, the Commission fined BNP Paribas HK$15m over the actions of its dark pool which, according to regulators, provided market materials to clients that misstated how it really operated. The pool – ‘BIX’ – also failed to disclose a service suspension for almost two years. Furthermore, in December securities regulators in Hong Kong fined a number of brokerage units of JP Morgan Chase HK$30m for alleged breaches, including charges related to the bank’s dark pool unit.

Despite the hand wringing over the best way in which to regulate the industry, it seems unlikely that dark pools will suffer considerably as result. Yet the SEC seems keen to push forward with new cases as SEC Chair Mary Jo White was quoted in February as saying, “I think you’ll see more dark pool cases”.

There are some suggestions that dark pools will plateau in popularity in the coming years. However, for now they remain immensely popular with investors, despite the scandals. The service they provide continues to draw traders away from open exchanges, and recent scandals may not be enough to entice them all back into clearer waters.

© Financier Worldwide


Richard Summerfield

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