Dark pools are trading venues with no pre-trade transparency, in that all orders are hidden as to price and volume and are anonymous. Although there are various recognised advantages to allowing dark pool activity, for example in terms of increased market stability through additional liquidity, and a potential beneficial impact on pricing and costs, regulators in Europe and the United States have are tending to take a more active role in controlling dark pool activity, as a result of concerns regarding the operation of dark pools.

Dark pool regulation: the global context

Recent investigations of dark pools in the United States (US), such as the fining by the Securities and Exchange Commission (SEC) and the New York Attorney General’s office of two banks, as a result of their improper operation of dark pools, for a total of 154 USD, have raised raised questions regarding potential inequality between users of dark pools and the ability of dark pool operators to mislead investors. The focus on these issues in the US can be seen as part of a general tightening by regulators globally on the regulation of dark pools, as is reflected by a specific focus on dark pools by the Financial Conduct Authority (FCA) in the United Kingdom (UK) and the development of a framework to control activities in dark pools at the European Union (EU) level.

The FCA thematic review: impact on asset managers

Although the FCA points out, in Thematic Review 16/5 (TR 16/5), that the regulation of dark pools in the US varies significantly from the UK,in terms of market structure and the approach to best execution obligations, the FCA in TR 16/5 specifically considers the regulation of UK equity market dark pools. The results of this review were generally positive, in that the FCA found that those operating dark pools were regulatory compliant, and that there were benefits in using dark pools. However, the FCA did identify a number of areas where improvement is required, and, although a main focus of the review was on the operators of dark pools, asset managers should be aware that the FCA made various suggestions to operators with the aim of improving the operation of dark pools. In particular, asset managers, as users of dark pools, should be aware that the FCA made clear that operators should:

Improve transparency of the operation of dark pools and promotional practices

This includes providing clearer detail to users about the design and operation of dark pools, in particular as regards how the dark pool interacts with the wider electronic trading platform. As part of this, users are under a greater obligation to take steps to ensure that they understand this detail. Users also need to show that they have conducted proper due diligence before transacting through a dark pool, so that they are clear why, how and when they are using or not using dark pools, and that they understand the operating model of the dark pool.

Improve the sometimes “weak” monitoring of dark pools

This means that dark pool operators are under pressure to increase their monitoring of operational integrity, best execution, user preferences, and unwanted trading activity, and so users should expect a more active role from operators in this respect.

Put more effort into identifying and managing conflicts of interest between users and between the operator and its users

This should be done by strengthening policies and procedures for oversight and conducting more frequent independent assessments. This should generally benefit users as a whole, as execution on dark pools should take place on a ‘fairer’ basis.

The FCA also warns users to be alert as markets evolve, for example as regards infrastructure changes at the firm or industry level, the emergence of new participants and shifts in technology. In this respect, the FCA notes that the MiFID II will be particularly significant.

MiFID II: The EU regulatory response

From January 2018, the regulation of dark pools will fall within the MiFID II regime. In TR 16/5 the FCA confirmed that this this will be the case, regardless of the impact of the U.K. referendum vote on EU membership. One of the core focuses of the MiFID II regime is on increasing transparency in the markets and, in light of this, MiFID II takes steps to reduce the scope for dark pools activity through the following means:

MiFID II introduces the OTF as a new type of trading venue to deal with more esoteric financial instruments, and mandates that shares are traded on a trading platform

As such, asset managers will have to execute transactions on regulated venues or through SIs, unless the transactions are non-systematic, ad hoc, irregular and infrequent, or do not contribute to the price-formation process (as determined by the MiFID II implementing measures).

MiFID II introduces a volume cap on dark trading of equity and equity-like financial instruments through the so-called double-volume cap mechanism

The purpose of this is to protect price formation, by capping some pre-trade transparency waivers (the reference price and negotiated trade waivers) at certain levels. The volume traded through the use of pre-trade transparency waivers by any trading venue will be limited to less than 4% of the total on-venue trading across the EU in any equity or equity-like instrument, and the aggregate volume across all trading venues through the use of pre-trade transparency waivers will be limited to 8% of total on-venue trading across the EU in any equity or equity-like instrument. If trading exceeds either of the caps, the use of the waivers is suspended (across the EU or at the level of a trading venue) for a period of six months.

MiFID II restricts reference prices

MiFID II restricts reference prices, which can be used by reference price systems to benefit from the reference price waiver from pre-trade transparency, to the primary market (i.e. the venue where the financial instrument was first admitted to trading) or the most relevant market in terms of liquidity.

For continuous trading, only the midpoint between the best bid and best offer will be a permissible price for execution of an order on a system to which a reference price waiver has been granted.

MiFID II will require for all trading venues and SIs, lit and dark, to publish a quarterly report containing detailed information about the quality of execution throughout the period

Asset managers will have to make public on an annual basis information on the top five venues by execution volume, as well as information on the quality of execution obtained.

Next steps

Asset managers need to carefully consider the changes to their existing and planned business models in light of these new MiFID II rules, and need to be able to show that they have taken adequate steps to implement the relevant requirements.