Every Trade Counts: Dark Pools as Alternative Infrastructures
The growing presence of high-frequency traders in Alternative Trading Systems (ATSs), or dark pools, raises concern about market fragmentation causing pockets of illiquidity and hindering price discovery. In response to these concerns, international regulators have started reviewing existing regulations and their impact on dark pools. While the U.S. Securities and Exchange Commission (SEC) has only begun its review, European and Canadian regulators are ready to implement new regulations. In our judgement, the simple market-based Canadian approach is a better template for future U.S. regulatory reform than the more arbitrary and bureaucratic European approach.
Alternative Trading Systems, also known as “dark pools,” are trading venues where transactions take place and are settled outside of public exchanges and trading platforms. Access to many dark pools is controlled by their owners, often large investment banks (acting as market makers) such as Goldman Sachs, Credit Suisse, Barclays, and asset managers including Fidelity, Vanguard and UBS.
One catalyst for their rise is the need for institutional investors to lower the transactions cost associated with trading large blocks of securities while minimizing the impact on market prices. For market makers and large asset managers, there is often sufficient “in-house” turnover among a firm’s diversified portfolio of funds that changes in the supply and demand for certain securities can be satisfied internally, and without having to go out to the public exchanges. Such transactions are considered “dark” because the underlying bid and ask prices are not recorded on the public exchange because the buying and selling are confined to the firm's internal marketplace.
Dark pools are attractive for portfolio managers because they lower costs by allowing large blocks to be traded internally, often by resizing them according to the needs of various in-house portfolio managers. By comparison, a large block of securities either offered or bid in the public exchanges is transacted on an all-or-nothing basis and may arouse undesirable speculation about potential changes in the strategic outlook of the firm’s portfolio manager. Dark pool transactions prevent such speculation and the risk of contagion.
Critics of dark pool transactions argue that the lack of transparency may hinder efficient price discovery and limit market liquidity. The fragmentation between stock exchanges and off-exchange platforms raises concern that the unrecorded trades may prevent public exchange prices from accurately reflecting underlying supply and demand conditions for all securities, and possibly disadvantage investors without access to the dark pools (e.g., small retail investors). Isolated dark pools may also amplify the buildup of excess or deficient liquidity in the public exchanges.
Furthermore, the evidence is suggesting that pricing in the dark pools is being disrupted by high-frequency trading firms. Their presence in the alternative trading venues (often front-running large block trades) has the potential to undermine the usefulness of dark pools for institutional investors. Front-running makes it more expensive for fund managers to place large block trades.
In response to these concerns, European regulators have already started the process of replacing regulations on markets in financial instruments (Mifid I) with a more restrictive approach, known as Mifid II. Its aim is to limit off-exchange trading and restrict the presence of high-frequency trading.
The purpose of Mifid II is to restore market integrity by having administrators simultaneously regulate activities, types of financial instruments and trading venues in securities markets In the meantime, it provides various exemptions known as “special rulings” that are totally based on regulators’ assessment of the market. The two key exemptions from Mifid II are: regulators can remove the volume caps based on the type of securities or the size of the trade when it is “considerably” large. These special rulings seem to favor non-HTF activities. Such special rulings, however, may create legal loopholes and result in even more fragmented market with less reliable liquidity.
By contrast, Canadians adopted a more minimalistic approach. Their aim is to achieve market integrity by providing right incentive and targeting a single mandate for all trades, namely trades are allowed if they contribute to “price improvement.” The price improvement criteria means that regulators allow trades to be routed to the dark pool if the dark pool provides a “better price” for the investor initiating the trade than is available on an exchange. The location of the transaction will be determined by such a market mechanism.
It is unlikely that fragmentation or the questions of price discovery will disappear. However, among the options that are under consideration, we believe a simpler, the less restrictive and more market-based tactic seems to be a better choice for the U.S. This means walking away from the complex European strategy and move toward the simple and more pragmatic Canadian approach.
 Market liquidity is the ability to buy and sell whale-sized trades without changing the prices.
A lawsuit brought by New York State attorney-general in 2014 as well as SEC charges in 2016 accelerated this concern by regulators.
 Both MiFID II and MiFIR entered into force on 2 July 2014 and must generally apply within Member States by 3 January 2018.
 One year before its full implementation, the European Securities and Markets Authority (Esma) has started to collect data on 15 million financial instruments from more than 300 trading venues.