NZX has published its regulatory agenda for 2017 setting out its regulatory priorities and resourcing, and the outcomes it seeks to achieve over the coming year. In both the 2016 and 2017 regulatory agendas, NZX has flagged 'dark pool' arrangements as a continuing trend in technological innovation that is increasingly prevalent in New Zealand and on NZX's markets.
While dark pools have benefits for efficiency and cost effectiveness in order execution, they also have the potential to result in abnormal trading and can pose a risk to market efficiency and integrity, and to the transparency of market liquidity and the price discovery process.
What is a 'dark pool'?
'Dark pools' are arrangements that involve direct off-market trading in listed securities, usually between market participants and institutional investors. In effect, dark pools provide users with an alternative trading venue to a public exchange, such as one of NZX's markets. 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.
Originally this enabled institutional investors to trade large block orders confidentially and at better prices than those possible on a 'lit' public market, without the risk that the size of their order would result in an unfavourable price movement against them. The idea being that this liquidity could provide smoother trading and mitigate large price swings or market dislocation.
More recently, trade sizes in dark pools have dropped to the point where they are largely indistinguishable from the public 'lit' markets. There are now concerns about the changing nature of dark liquidity and its impact on efficient price formation, as well as questions about the fairness of dark venues for investors.
As pointed out by the Financial Markets Authority (FMA) in its Strategic Risk Outlook for 2017, New Zealand is an importer of global regulation. With that in mind, we take a look at the international approach to dark pools and some of the pinch-points raised by other regulators and exchanges.
The Australian Securities and Investments Commission (ASIC) released its first report on dark liquidity in early 2013. The initial report identified the following concerns:
- Market quality: The growth in dark trading had impacted on price formation with bid-offer spreads widening.
- Queue jumping: Block-size trades were able to trade ahead of orders in the lit market at the same price leading to a lack of fairness and reduced incentives to contribute to price formation by placing orders in the lit market.
- Liquidity: The existing block tier threshold did not have any flexibility to account for differences in liquidity in determining the price impact of large trades.
ASIC's response was to introduce two rule changes to the market integrity rules that have affected both block size and below block size trading:
- Tiered thresholds for block trading: The previous 'block trade' exception to pre-trade transparency was amended from a flat AU$1 million threshold to a tiered threshold of AU$1 million for the most liquid equity securities, AU$500,000 for comparatively liquid equity securities and AU$200,000 for all other equity securities.
- Meaningful price improvement rule: This rule requires trades that are conducted in the dark in small sizes (that is, below block size) to provide meaningful price improvement. It was anticipated that this rule would lower the proportion of below block size trading and encourage more trading on the lit market. The intention was also to protect lit orders from being queue jumped by dark trades at the same price.
These regulatory changes were most recently reviewed by ASIC at the end of 2015 with the review concluding that the regulatory settings have been largely adequate and effective.
The UK's Financial Conduct Authority (FCA) published the results of a thematic review of dark pools in the UK in the middle of 2016. A full analysis of the FCA's review from our offices in the United Kingdom can be found here.
The FCA found some benefits in dark pools but also acknowledged concerns that price transparency and price formation may be at risk if dark markets, which derive their prices from lit markets, become disproportionately large compared to lit markets.
It noted some poor practices and areas of improvement for UK dark pool operators, including:
- Client on-boarding and preferences: Dark pool users may be sensitive to who is swimming in the pool with them and operators of UK broker crossing networks generally offer the ability to restrict counterparties against whom an order is allowed to execute. For example, users may not wish to interact with high frequency traders. The FCA found that operators were not sufficiently systematic in ensuring the prevention of trades with restricted counterparties, and that this could lead to those operators not meeting their best execution obligations.
- Operational design and integrity: The FCA considered how operators manage the conflict between routing an order in the client's best interests and operating the dark pool. The routing of orders to the operator's own broker-crossing network before routing elsewhere is acceptable provided that the operator can evidence it has adhered to best execution obligations. The FCA also identified the poor practice of in-house trading desks being granted access to broker-crossing networks via different infrastructure to clients, which gave operators a potential timing advantage, constrained only by management controls.
- Monitoring of activity in the pool: ZMonitoring capacity was the weakest area of the dark pool trading process identified by the FCA. It 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. The FCA acknowledged the challenges for monitoring in an ultra-fast environment but stressed that all operators must be able to monitor to ensure that best execution obligations are met and to correct any deficiencies.
Both the US Securities and Exchange Commission (SEC) and the US Financial Regulatory Authority (FINRA) are actively involved in the regulation of dark pools.
Since 2014, FINRA has required the weekly publication of dark pool trading data on a security by security basis - albeit after a two to four week delay depending on the type of security. The SEC also began a two-year pilot program in 2014 that, in part, tests a rule requiring securities traded in the dark to be sold at a meaningfully better price than what is available on public 'lit' markets.
In November 2015, the SEC proposed further enhancements to its regulatory regime for dark pools. These would require dark pool operators to make public disclosures about the nature of their trading operations including information regarding potential conflicts of interest. The objective is to make the dark pool trading venues more transparent so that participants can make informed decisions about where to send their orders.
Where to for New Zealand?
While there has not yet been any formal engagement with market participants on the issue of off-market trading, it is clear that both the FMA and NZX have dark pools in their regulatory sights.
NZX's recent consultation on an updated Guidance Note for Trading Conduct expressly states that, where possible, NZX Participants should endeavour to trade on-market as this will lead to a deeper and more liquid market with greater transparency. We can expect the following key principles identified in that guidance note to be relevant to any review NZX carries out on dark pools:
- Conflicts of interest should be appropriately managed.
- NZX Participants should always act in the best interests of the client.
- Markets should be fair, orderly and transparent.
- NZX Participants should have systems and controls in place to meet their requirements under NZX's rules and legislation.
- NZX Participants should follow good broking practices.
With the FMA's recently published guide to its view of conduct in mind, we can also expect the FMA to use 'conduct' as the lens through which it views both dark pool arrangements and the manner in which market participants and the NZX are meeting their regulatory obligations.