Darkness on the edge of town
Following the establishment of a temporary cap for dark pools on certain instruments in March 2018 by ESMA and the SEC’s decision for more transparency and oversight on dark
In our ODD practice, however, we see that usage has not decreased. As soon as we report that external asset managers use dark pools, we notice that this deters our clients. The word reputation risk and references to the book flashboys by Michael Lewis or to recent scandals is made quickly. In our view, the use of dark pools requires a balanced perspective.
Dark pools are not a new phenomenon. In the sixties of the last century this type of trading was called upstairs trading. The transaction did not go through the regulated exchange (eg NYSE, NASDAQ, AMEX) but the price and terms of the transaction were negotiated in the upper room with a broker.
MTF and ATS
Due to the rapid growth in the number of dark pools from the mid-1990s, regulators have developed guidelines and legislation to promote the structure of financial markets. In the United States the SEC speaks of Alternative Trading Systems (ATS) to designate, among other things, dark pools, in Europe under MiFID they speak of Multilateral Trading Facilities (MTF).
Current Market structure
The figure below roughly shows the market structure, with 11 regular exchanges, and the ATS / MTF with Electronic Communication Networks and the venues in which the dark trades take place. Of the direct internalization platforms, around 200 and 32 dark pools exist under FINRA supervision (in the US). 60% of the dark trades is done via direct internalization and 40% via dark pools.
What is a dark pool? A dark pool is a transaction facility for the purchase and sale of, among other things, listed shares outside the regular exchanges. In a dark pool there is no transparency (pre-trade transparency) about the price of the instruments in the pool and the counterparties prior to the transaction. This pre-trade transparency is there with ECNs. Dark pools are used to avoid adverse price impact with large purchase or sales orders and because of the lower transaction costs compared to the regular exchanges.
Where in the distant past the asset manager sent the orders directly to the regular exchanges, in the current market he has several liquidity venues at his / her disposal. As Justin Schack of Rosenblatt securities stated in a recent interview, nobody would think of the current market structure if someone could start designing from a blank sheet of paper. However, the current structure is not unfair and Schack even claims that investors are benefiting from the change in the structure. From the perspective of best execution, this is certainly true, especially when one realizes that best execution is not just about the cheapest transactions. ATS / MTF offer new, anonymous and fast options for making transactions.
It is up to the investor to determine how its asset manager uses an ATS / MTF, what checks and balances it has built in for use and price discovery (eg NBBO) and how the asset manager informs its clients about the added value of this use.
A subsequent blog will discuss the ratio between numbers of shares traded (in most portfolio of many Dutch pension funds) on the regular markets, compared to numbers of shares traded in the same period on Alternative Trading Systems (ATS) based on official FINRA data.