The buyside has a message for legislators in Europe: We like the anonymity of trading in dark pools, so don’t change the game with new rules that would force us onto public markets.
Dark pools remain a crucial option the buyside uses to trade large orders with minimal market impact, institutions have said. And the reforms to the Markets in Financial Instruments Directive–or MiFID II–would threaten that if they passed as they’re currently proposed. Legislators in Europe will address the proposals in May and could vote on them sometime in the fourth quarter.
Some institutions, such as Boston-based Wellington Management Co., voiced their opposition to new rules for dark pools in comment letters to the European Commission regarding the MiFID review.
"We oppose the unilateral imposition of regulatory burdens on the [broker crossing systems] segment of a firm’s trading operations without strong justification," Wellington wrote. "Such actions may serve to drive [broker crossing systems] out of the market landscape and cause more opaque, less regulated venues to gain share."
The comment period ran from Dec. 8 until Feb. 2. The proposals to reform MiFID drew a strong response from industry participants, as more than 4,200 letters poured in during the 56-day comment period.
The original MiFID directive took effect in November 2007 as a means to raise competition across the European Union at exchanges and other trading venues. It permitted new competition from ECN-like execution venues, called multilateral trading facilities–MTFs. Last year, the European Commission proposed a further review, MiFID II.
Among those measures that would affect crossing networks, whether dark pools or broker internalization engines, is a proposal to re-classify broker-dealer dark pools as organized trading facilities. Also, broker-dealer crossing networks that clear a certain volume threshold would be forced to register as MTFs. As a result, they would carry increased regulatory obligations. MiFID II also seeks to bring a degree of transparency to dark pools post-trade and to curb internalization, in general.
The Investment Company Institute, the national association of U.S. investment companies, isn’t taking the MiFID II plans for dark pools lightly. ICI felt strong enough on the matter to comment on this topic, given that it represents institutional investors of more than $12 trillion of assets from more than 90 million individual shareholders. ICI data show that, as of September 2010, U.S.-based long-term mutual funds held $2.1 trillion in non-U.S. securities, accounting for almost 25 percent of the assets of these funds.
Dark pools, ICI wrote in its letter to the EC, not only make it cheaper to implement trading ideas, but also lessen the risk of information leakage. And they let funds avoid interactions with market participants who want to profit from the public display of large orders to the detriment of funds and their shareholders.
"The importance of funds being able to trade efficiently in large size cannot be discounted," the ICI wrote to the EC. "The confidentiality of information regarding fund trades is of significant importance to ICI members. Any premature or improper disclosure of this information can lead to frontrunning of a fund’s trades, adversely impacting the price of the stock that the fund is buying or selling."
The proposals were made due to regulators’ concerns surrounding the effects dark pools have on price discovery in Europe. But gauging the impact dark pools have isn’t easy. That’s because transaction reporting across the heterogeneous continent is difficult, Investment Technology Group noted in a recent study on ATSs in Europe.
In February, ITG looked at numbers from the past two years in Europe to determine how much effect alternative trading systems have been having on price discovery and trading costs. It found in its study, "ATSs in Europe: Post-MiFID performance," that 2010 data showed that transaction costs in dark pools was 13 percent lower than those of regulated primary markets, and 18 percent lower relative to those of "lit" MTFs.
The study looked at order and execution data from ITG Europe, a liquidity aggregator. It analyzed nine dark pools, four displayed MTFs and the registered exchanges over the first 10 months of 2010. The numbers included more than 438,000 orders and 4.8 million trades.
"Dark pools continue to add value relative to MTFs and primary markets in 2010, as measured by trading transaction costs," The ITG study concluded. "Dark pools provide significant added value for all market capitalization groups, with the exception of the most liquid securities. Breakdowns by country of listing do not change the qualitative nature of the results."
Dark pools have carved out a significant, yet nowhere near dominant, segment of the European markets, Rob Boardman, ITG’s head of European operations, told Traders Magazine. He estimates that 10 percent of total volume in Europe is dark. Dark pools saw their largest growth in Europe in 2009 and the early part of last year, Boardman said. But dark volume stabilized a bit over the past six months, he added.
"Probably the long-term trend is up," Boardman said. "But it’d be totally wrong to say that dark trading dominates European equities."
Nevertheless, restricting the amount of trading in the dark is unhealthy for the markets, said Miranda Mizen, principal and head of European research for The Tabb Group. The buyside will probably hold onto more order flow if it cannot easily use dark pools to hide it. Brokers lacking the same options, on the other hand, will likely make capital more expensive, Mizen said.
"If you clamp down on dark pools," she said, "you get all sorts of consequences that go with this."
