On 21 July 2016, the FCA published a report on its thematic review of the UK equity marketplace, focusing on dark pools and broker crossing networks ("BCNs").
Equity market dark pools, which have existed for more than a decade, are trading venues with no-pre trade transparency where the price and volume of all orders are hidden and anonymous. The lack of pre-trade transparency is designed to help institutional investors, like pension funds and asset managers, to trade large blocks of shares without the market moving against them. Operators of dark pools must adhere to FCA principles and regulations, including best execution, regardless of processing speed or the size or relative sophistication of the trading operation and infrastructure used.
The changing technological environment of the UK equity market presents new challenges in the identification and management of risks. In recent times, dark pools have come under increasing scrutiny in respect of price transparency, perceived unfairness and the potential exploitation of some dark pool users by dark pool operators or other more technologically advanced dark pool users which, in part led to the review. The FCA focused on promotional activity and the identification and management of conflicts of interest by dark pool operators.
Dark pools can provide benefits to users in terms of additional market liquidity, the lower risk of information leakage on trading activity, price improvement and reduced overall trade costs. The report identifies that firms operating dark pools have made significant and innovative change with a continuing commitment to infrastructure investment. However, while some users and operators have invested heavily in infrastructure and/or updated policies and processes, particularly in addressing promotion and the management of conflicts of interest, the FCA identified a range of deficiencies that are still apparent in the report. The report set out good and bad practice findings, with guidance offered on improvements for both operators and users.
Improvements that could be made by operators, included the need to:
- Provide clear detail about the design and operation of a dark pool to users. No two pools are exactly alike so operators should ensure that disclosure or distributed materials on the services, key features and/or options offered by an internal crossing network are comprehensive, clear, fair and not misleading. Further, operators should engage in discussions with users/clients to ensure that these materials are understood.
- Improve the monitoring of activity in pools with a focus on operational integrity, best execution, client preferences and unwanted trading activity including market abuse. The onus is on the operator to have adequate controls and oversight to ensure that all services, features and/or options made available to users consistently operate as designed and intended; and
- Do more to identify and manage conflicts of interest (user vs. user and operator vs. user) including the strengthening of policies and procedures for oversight and escalation and regularly refreshing independent assessments.
Improvements were also identified for users and in particular asset managers: best practice includes being clear about the rationale for using dark pools and conducting sufficient due diligence to understand thoroughly the operating model of each pool accessed. There can be significant differences between pools and users must bear this in mind. Users should also improve their monitoring of results versus expectations when using dark pools.
The UK market and its regulation, has some key differences from other national markets and regions. By way of example, the US and UK vary significantly in terms of market structure and the approach to best execution obligations. As such, conclusions drawn about operations in other markets may not be applicable or have not been evident in the FCA's review of the UK market.
Users and operators review the guidance in the report and their current processes. It is vital that they remain alert as markets evolve and ensure that business practices are fit for purpose and supported by appropriate second line of defence controls.
The FCA noted that the proposed regulations under MiFID II will have a significant impact on the market. Notwithstanding the Brexit vote, the FCA has made it clear that financial firms should still prepare for implementing the MiFID II securities reform.
Users and operators will need to consider the new MiFID II rules and the impact on existing business models. Much financial regulation currently applicable in the UK derives from EU legislation, which will remain applicable until any changes are made by Parliament. Such changes are unlikely to be made in the short term and as such, firms must continue to abide by their obligations under UK law, including those derived from EU law.
The FCA will continue to monitor users, operators and market activity as it relates to dark pools and other sub-markets.