On 21 July 2016, the Financial Conduct Authority (FCA) published the results of a thematic review, in which they examined 'dark pools' - trading venues with no pre-trade transparency, where the price and volume of all orders are hidden and anonymous. These include broker crossing networks (BCNs) and 'dark' Multilateral Trading Facilities (MTFs). The FCA found that users welcome the additional liquidity, the lower risk of information leakage and the potential beneficial impact on pricing and costs that dark pools offer. The FCA thematic review did not observe any failures to comply with regulatory requirements but did identify a number of areas where improvement is required by dark pool operators.
In light of the FCA's findings, dark pool operators should:
- review promotional materials to ensure they clearly and consistently explain pool operation to users and ensure there is a robust internal governance process for the review and approval of marketing material with legal/compliance oversight
- improve the monitoring of activity in their pools with a focus on operational integrity, best execution, client preferences and unwanted trading activity including market abuse; an
- do more to identify and manage conflicts of interest, including strengthening policies and procedures for escalation and oversight, as well as regularly refreshing independent assessments.
Dark pools, market fragmentation and regulatory change
Dark pools provide users with an alternative trading venue to public exchanges, such as the London Stock Exchange. By trading 'in the dark' as opposed to on 'lit' markets, dark pool users do not disclose the size or the price of their trades to the wider market. Historically, this enabled institutional investors to execute large block orders at better prices than that which was possible on lit markets, where the size of their order would result in an unfavourable price movement against them.
Today, dark pool users may a have mix of orders with differing objectives underway at any point in time and spread across a number of dark and lit trading venues. The breaking up of a single order (parent) into smaller (child) orders, once the preserve of more sophisticated traders, is now common practice and built into the vast majority of automated trading activity. Dark pool users are wholesale investors. The FCA noted that while retail investors may have all or part of their order processed by a broker in a dark pool, there are no operators who provide retail clients with direct access to UK dark pools.
The FCA’s thematic review comes in the context of increasing technological advances in electronic trading, and significant fragmentation of the UK equity market. Whilst the FCA noted that electronic trading across multiple trading venues, including dark pools, has led to higher speeds and lower costs, the regulator acknowledged concerns that price transparency and price formation may be at risk if dark markets, which derive their prices from lit markets, become disproportionally large compared to lit markets. The FCA stated that at present, dark market volumes are considered too small to pose an imminent threat to the price formation process, but that they would continue to monitor market developments.
The FCA reminded dark pool operators that the upcoming MiFID II regulations will have a significant impact on wholesale markets, including a direct impact on BCNs, which represent a sizeable component of market liquidity. Whether and how firms may choose to restructure their existing businesses, including dark pools, remains uncertain pending the finalisation of MiFID II rules.
The FCA thematic review involved a desktop review of practitioner and academic research, as well as marketing materials produced by dark pool operators since 2014. The FCA then sought detailed information from a sample of dark pool users and operators. After reviewing this information, the FCA met buy-side investors who are significant users of dark pools. From these discussions, the regulator sought to understand the user experience as these markets have evolved, the role of dark pools in their trading activities and specific issues that they thought worthy of note.
The FCA then met with operators of dark trading venues, primarily focusing on BCNs, but also meeting dark MTF operators, to evaluate the products and services they provided, their governance structure and the identification, management and disclosure of conflicts of interest.
Areas for improvement
The FCA found that dark pool operators have responded to public concern and regulatory interventions by addressing business model design, promotional materials in use, and the management of conflicts of interest. Nonetheless, poor practices and areas for improvement were identified. A number of these areas are highlighted below.
Client onboarding and preferences
Users are sensitive to who is in the pool with them. BCN operators generally offer their users the ability to restrict counterparties or counterparty types against whom their orders are allowed to execute. For example, users may choose to restrict or wholly avoid interaction with high frequency traders (HFT) or electronic liquidity providers (ELPs). Whilst operators noted that the number of users making use of these restrictions was small, the FCA found that the collection, storage and processing of these preferences was difficult to audit, and systemically weak across the industry. The FCA also found that dark pool operators were not sufficiently systemic in ensuring the prevention of trades with restricted counterparties. As a result, a user may find its order being matched with a counterparty that it has a clear preference not to trade with. Weak processes may give rise to the risk that the dark pool operators are not meeting their best execution obligations. Best execution obligations include the obligation to ensure that orders are executed in line with specific client instructions where provided.
Operational design and integrity
The FCA also considered how dark pool operators managed the conflict between routing a client's order in the best interest of the client and operating a dark pool. The FCA noted that bank operators consistently route orders to their own BCN pool before routing elsewhere. The FCA stated that this was acceptable, provided that operators adhere to best execution obligations, avoid positive or negative venue discrimination, manage resting times and support and evidence all of the above by actively monitoring trade activity.
The FCA also observed that some operators sent client orders to their own BCN pool and then forwarded orders automatically (partially executed or otherwise) to other BCNs under a Reciprocal Access Agreement. Router technology can stipulate basic order instructions but may not necessarily preserve specific client preferences. The FCA observed that users were not clear on whether their preferences were preserved under onward routing and had no way to monitor or verify if those preferences were honoured.
The FCA also identified the poor practice of in-house trading desks being granted access to BCNs via different infrastructure to clients, which gave operators a potential latency advantage, constrained only by management controls.
Monitoring of activity in the pool
The FCA stated that monitoring capacity was the weakest area of the end-to-end trading process related to dark pools that the regulator identified in the thematic review. The regulator noted that the ability to analyse and report on individual client transaction-level trading activity on the same day is beyond the technical capacity of most operators; as most take several days or a week to generate reports. Whilst the regulator acknowledged the challenge of trade monitoring in an ultra-fast environment, the regulator stated that all operators must be able to monitor and ensure that they are meeting their best execution obligations, and correct any deficiencies where appropriate.
All pool operators have responsibilities to monitor for market abuse, the integrity of their operational platform and those features which they have promoted as attributes of their pool. Where operators purport to be able to identify and protect against unwanted activity ('toxicity' or 'aggressive HFT' for example) they must ensure that they have in place appropriately and clearly defined metrics and controls in order to be able to effectively monitor and take action against firms that exhibit unwanted types of activity.
Key regulatory messages
- Dark pool operators need to provide clear detail as to the design and operation of a dark pool - particularly how it interacts with other activities on the operator's wider electronic trading platform.
- Operators should improve the monitoring of their dark pools - in particular, operational integrity (accuracy of reference pricing, capacity, stability), best execution (where applicable), client preferences and unwanted trading activity.
- Operators should do more to identify and manage conflicts of interest, including both client vs client and operator vs client.
- Users should be clear about their rationale for using or not using dark pools, and conduct adequate due diligence to understand the pool operating model.
- Operators should improve governance and the strength of the second line of defence, which the FCA noted was weaker than expected.
- Users and operators should remain alert as markets evolve, particularly regarding the emergence of new participants and the shift of technological advantage among participants.
- Users and operators should careful consider the new MiFID II rules and the impact on existing and planned business models.