European Dark Trading: A Question of Clarity

As politicians look to finalise regulation on dark trading in Europe, their main objective is to increase transparency, but the latest proposals to restrict dark trading at 4 and 8% have the potential to inadvertently create greater opacity as well as seriously impact institutional investors ability to execute order flow. Only 14% of institutional investors do not have concerns regarding the introduction of the volume cap proposals. The vast majority anticipate being forced to return to more traditional forms of execution. The Commission perceive that the introduction of this regulation will not lead to a disrup-tion of trading despite the fact that if an individual cap in an instrument is breached, the national competent authority which authorises the use of this waiver will be obliged to sus-pend it for a period of 6 months.

The recent decline in trading activity from bilateral OTC trading versus the increase in au-tomated dark venues has enabled institutional traders to become more autonomous from brokers in their endeavours to maximise returns for investors. The increased usage of fix protocol tagging, venue analysis and TCA allows greater post trade transparency which provides the correct level of pre-trade transparency without negatively impacting the insti-tutional trader in the process, ultimately offering the buy side improved choice in venue selection. 84% of European institutional investors now use TCA enabling institutional investors to deliver enhanced performance for pensioners and savers.

Opponents claim dark trading is costing investors billions and have called on regulators to introduce dramatic changes. The reality is dark trading has always existed. The differ-ence now is that rather than the buy side turning de facto to the sell side to execute a block on their behalf, they are choosing to take control of their order flow – when, where and how it is executed. As such 98% of institutional investors now choose to access alternative liquidity pools in their hunt for anonymity and reduced market impact.

As retail investors increasingly outsource their wealth to institutional managers through mutual funds or ETFs, the concentration in asset managers and resulting homogeneity in trading decisions, partly driven by benchmarking, has resulted in fewer, but larger and more challenging trades to be executed in an environment of declining turnover. This cou-pled with greater automation equals an increase in the volume executed by HFT and mar-ket makers and a decrease in the volume executed by long-term fundamental and buy-to-hold investors. The ability to reduce the signalling of trading intentions has been compounded by an overall decline of European trading volumes by 49% since 2008 – thin volumes expose trading intent and impact performance as a result. Combine this with a reduction in available risk capital for the majority of European buy-side participants and it is easy to see why the protection, liquidity and price improvement institutional inves-tors find in the dark hard to ignore.

In reality there is little incentive to take the risky option of sending an order for a possible match in a dark pool when a lit match at the same price is available. For every order there will be a critical trade-off between certainty of execution versus enhanced perfor-mance. If you are prepared to wait passively, you avoid having to pay the spread. For institutional investors this difference can have a substantial impact on fund performance and therefore underlying pensions. It is critical to maintain the element of choice.

The growth of automated dark pools has enabled liquidity to be democratized rather than remain locked in a handful of exclusive bilateral relationships. Yet levels of darkness amongst the pools themselves vary. No two dark pools are the same, and venue perfor-mance may fluctuate according to external market conditions as well as the individual or-der being executed. The underlying activity of individual pools needs to be understood.

The ability to measure performance and the potential toxicity of certain dark pools will be far more valuable in the longer term. Ultimately the buy side will vote with their feet, and the ability to correctly analyse individual venue performance will determine where institu-tional investors choose to trade. In the current economic environment that is what is most essential - maintaining the element of choice. There is no other industry in the world where intermediaries would be penalised for endeavouring to get the best price for their client – the end investor.

As trading becomes further divorced from the research process, proving best execution has been delivered will be critical. Full disclosure of execution, dark or lit, will become mandatory. Regulation would achieve greater transparency by “cleaning up” dark trading, clarifying the rules within an appropriate framework to maintain choice for the benefit of the underlying investor, rather than obliterating dark pools in their entirety.

Regulation should now focus on improving the quality of post trade data to dispel the con-fusion that has historically been linked to the dark: now is the time for clarity.