Agency broker Instinet became the third dark pool operator in Canada’s equities markets, when trading began on its two new venues this week in the small but growing niche of undisplayed liquidity.
The two new dark pools are Instinet’s first in the market and are designed to increase the level of block trading in Canada, according to Peter Coffey, managing director at Instinet Canada Cross. The two new pools are also in compliance with Canadian regulators’ desire to foster block trading while at the same time providing users with price improvement.
To date, dark pools are not big in Canada. The only two in operation now both have U.S. origins. Given the trend in Canada towards increased use of algorithms, dark pools are seen as a natural development there. But some on the buyside are skeptical as to whether Instinet’s foray will increase dark pool volumes.
"Dark pools have not gained much traction in Canada so far, and will adding another change that? I don’t know," said Kelly Reynolds, director of trading at Ontario-based Hillsdale Investment Management. She’s more inclined to wait-and-see how the pools’ details shake out before jumping in.
The first dark pool from Instinet is BLX, an algo-friendly venue that builds block trades by accumulating many smaller orders until a volume threshold is reached. It is targeted at passive block traders and users of algorithms. It features several built-in "anti-gaming" features, such as volume triggers and a mid-point pricing window, to prevent the system from being gamed or "pinged" by high-frequency traders.
The idea that HFTs will have trouble gaming her orders based on the uncertainty of the execution price, random execution within a 10-second pricing window, appeals to Reynolds, but this creates the same price uncertainty for her trades.
"The BLX crossing facility is a completely new concept in Canada and might gain some traction here," she said. "As an institutional trader, I have a lot of questions on how well this is going to work. But still, having a dark pool designed with anti-gaming features that are unappealing to the HFTs is a good thing for us."
BLX executes a trade at a random midpoint price generated from the orders within a 10-second window. HFTs will likely have trouble estimating just when the trade goes off, which is a plus for the buyside. However, the buyside doesn’t know exactly at what price it’s getting filled, either. Reynolds said that for liquid stocks with tighter spreads this methodology might be very effective, but it is not as ideal for names with wider spreads.
The second dark pool, VWAP cross, is nothing new, said Reynolds, and has been attempted in Canada before by other firms. Instinet’s iteration works by crossing orders each day at 9:15 a.m. ET and locks them in for the trading day. Trades are priced and printed after the market close, set for 4:15 p.m. ET. That is after the stock’s volume weighted average price has been determined using the day’s consolidated market data feeds from all visible Canadian markets. The dark pool supports market orders, minimum fills and cash constraints on baskets.
"I don’t think this one [VWAP cross] will attract any relevant portion of market share," Reynolds said. VWAP crosses have been available in Canada for many years. "Personally, I don’t like the idea of being locked into a VWAP trade."
Doug Clark, managing director at ITG, which operates a rival dark pool, also expressed concerns, saying the VWAP cross has limitations. "It’s a very tough sell to say to someone that when they enter into an all-day trading facility like that, they will not be able to get out when they want," Clark said.
He said VWAP cross strategies are always difficult and said traders are not able to place limit orders or volume constraints, such as limiting a trade to a percentage of daily volume, which can hurt the buyside. An event such as last May’s "flash crash" expose this very weakness for VWAP trades.
Instinet defended its product and the strategy, saying VWAP crosses work well in a low volatility trading environment, akin to what the market is experiencing currently, where prices don’t vary much intraday. However, the dark pool won’t help traders when volatility spikes during the day, or if there is a market disruption where prices swing wildly.
Up to now, Canadian regulators have been cautiously watching U.S. dark pool trading and have been talking about jointly proposing updates to existing rules that would effectively curtail U.S.-style dark pool trading. Behind the thinking is a long history of transparency in a marketplace which requires all trades to be taken to an exchange or otherwise "lit" market to be printed.
Some speculate Canada’s three regulators could introduce rules that limit dark pools. The Canadian Securities Administrators, the Ontario Securities Commission and the Investment Industry Regulatory Organization of Canada haven’t proposed anything as of yet.
Regulators are contemplating the imposition of a minimum trade size clause that would bar the execution of any order under 5,000 shares in a dark pool. Orders smaller would automatically be routed to the exchanges.
Despite the regulators’ concerns and a potential minimum trade size requirement, growth in the Canadian dark pool market is expected to continue, according to ITG’s Clark. He said Goldman Sachs plans to launch its Sigma X dark pool sometime in June, and he has heard that other bulge firms, such as Credit Suisse, Morgan Stanley and Bank of America Merrill Lynch, are also getting ready to cross the border.
"We’re going to see a number of new pools come here that are designed to be more innovative and more cost effective than what is already here," Clark said. "If they add more options to clients on where to trade, offering more choice and flexibility, then that is a positive development."
Conversely, if more pools add confusion or siphon off too much trading from the lit markets, then new additions could be a problem and stir the ire of regulators, he added.
Up until now, the only dark pools operating in Canada were from U.S. brokers; Investment Technology Group’s via TRiAct Canada MarketPlace and Liquidnet Canada. According to ITG, it trades 3 percent of total daily volume. The other dark pool, Liquidnet Canada, specializes in providing block liquidity to the buyside. It sees less than 1 percent of total daily volume.
Dark pool trading in Canada accounts for about 2.7 percent of the volume, whose total accounts for 634 million shares trade per day, according to research firm Forefactor, an industry consultant. A drop in the bucket compared to the 12 to 13 percent of U.S. trading volume that comes from dark pools and crossing networks.
"By the end of the year, I wouldn’t be surprised if Canadian dark pools’ share of daily trading volume rises to five percent of total market share," said Clark.
