Dark Matters

European dark volumes have now reached in excess of 10% of equity trades. Only 6% of asset and fund managers interviewed do not trade in the dark, versus 15% in 2011, and those who do trade have increased their participation levels. With the increase in volumes traded away from the primary exchange, European politicians perceive a need for greater supervision of dark venues. Proposed regulation to impose a volume cap on the reference price waiver, together with the introduction of a restricted Organised Trading Facility (OTF) will, they believe, limit trading in non-transparent markets and return volumes onto exchanges, enabling investors to detect a credible price signal.

However, there is no guarantee that this will happen. As exchanges have moved from a mutualised to for-profit model, their need to attract market participants creates a greater conflict for asset managers executing institutional order flow. Initiatives to facilitate market-making flow can attract short term-investors that may be damaging for institutional activity. Displaying the asset manager’s intentions before they can execute enables shorter-term investors to profit ahead by trading against institutional investors. Poor execution impacts fund performance; as a result, 85% of the buy-side participants interviewed now actively select alternative liquidity pools away from primary exchanges in their hunt for anonymity and reduced market impact (see exhibit).

There is a real danger that the proposed regulation will shift institutional order flow to further obscurity via over-the-counter (OTC) phone trading or even to new order types, such as the increased use of negotiated trade waivers seen in Italy. Politicians may want greater transparency but by trying to push all order flow onto primary exchanges, they will harm the very pension funds and retail investors they claim to want to protect.

This research looks at the rise of dark trading, its increasing influence on the current equity trading environment, and possible improvements that could be made to increase transparency, without inadvertently impacting liquidity. Our findings are based on 94 interviews conducted during the past year with institutional asset managers trading European equities. Between them, these respondents have worldwide assets under management (AUM) of more than €14.2 trillion.

Recommendations

While trading via alternative liquidity pools is on the increase, this should not pose a problem, provided this avenue of execution allows asset managers to achieve improved pricing for institutional order flow.
However, there is more that can be done to improve transparency within alternative liquidity pools and although significant progress has been achieved, room for improvement remains. The buy side would welcome better insight into market activity.

To achieve this transparency, TABB Group recommends the following processes be implemented prior to additional regulation of alternative pools, which could inadvertently damage liquidity and the ability to execute institutional order flow in the process:

1. A mandated consolidated tape with harmonised reporting standards.
FIX tags such as 28, 30 and 851 will eventually create greater transparency as to the trading behaviour of individual venues against individual stocks. What will become increasingly important will be creating a similar level of transparency for phone/voice-order execution as for automated/algorithmic trading.

2. Calibrated transparency requirements for large, mid and small-cap stocks.
By developing market-specific benchmarks (based on spreads and/or volumes traded, for example) rather than blanket legislation, the accuracy of price formation can be better assessed, and more effective decisions can be made pre-trade. In particular, a recalibration of the Large In Scale waiver to more practical levels based on average daily volumes (ADV) traded or nominal market size (NMS) would benefit institutional trading.

3. Retention of the equity OTF but with limited and simplified categories and order types.
The simplification of market structure will ensure clarity of the rules and should include standardisation of client facilitation of order flow, restrict onward routing, and ensure the minimal number of order types.

4. Ensure flexibility within the rules by basing these on technical guidelines via a pilot scheme, delegated to the European Securities and Markets Authority (ESMA).
With a focus on prevention rather than cure, improved data standards will increase robust monitoring and more effective supervision.