Views on improving the integrity of global capital markets
22 October 2014

Regulators Shining a Light on Dark Pools

Posted In: Market Structure

The regulatory net is continuing to tighten around dark pools as the list of badly behaved dark pool and high-frequency trading (HFT) firms grows. Indeed, Barclays is fighting allegations of misconduct relating to its LX dark pool in New York. CFA Institute has previously released a research report that highlights the issues surrounding off-market trading in dark pools. Issues relating to HFT have also received attention in this blog. The latest HFT case sees Athena Capital Research being fined $1 million for manipulating the NASDAQ closing price auction.

With regulators increasing their interest in how best to manage the fragmented exchange industry, we are continuing to see some industry players stepping ahead of the regulatory curve and attempting to find the best way forward. We have reported on IEX’s plan to neutralise HFTs using an artificial speed bump, and now we have another example of a firm trying to provide a safe trading venue for investors.

ConvergEx — a relatively small US dark pool firm — has announced a new business strategy and redesign for two of its dark pools. The first, Millennium, will become a venue where orders are guaranteed price improvement by executing only at the mid-point of the National Best Bid and Offer (NBBO). This resembles a price improvement rule, something that has been implemented by regulators in Canada and Australia already.

The second pool, Vortex, will allow participants to pay a fee to trade with less-aggressive traders and thereby avoid predatory algorithms. Currently, details about the size of the fee and what kind of traders would be approved as counterparties are not available. This isn’t the first dark pool to have this functionality. Barclays’ LX dark pool claimed to do the same thing, although it is currently being sued by the New York Attorney General for misleading investors about the presence of predatory HFT.

It will be interesting to see whether these trading venues find success. Institutional investors often complain about unfair predatory HFT strategies, but now with IEX and ConvergEx they will have seemingly safe alternatives (assuming these dark pools work as advertised). Clearly these smaller trading venues may have lower depth, but the extent of their success will also help to determine whether market participants think that the liquidity improvements resulting from some algorithmic and passive high-frequency trading strategies outweigh the perceived or realised costs of predatory HFT strategies.

Further, if these technical, self-regulating solutions end up offering a satisfactory way for institutional investors to obtain fair execution for their trades, it would presumably lower the pressure for regulators to “do something” about the HFT issue.

ERRATA (23 October 2014): Blog post was updated to reflect a clarification provided by ConvergEx relating to the settlement with the Department of Justice and the Securities and Exchange Commission of an unrelated fraud case.

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About the Author(s)
Sviatoslav Rosov, PhD, CFA

Sviatoslav Rosov, PhD, CFA, is Director, Capital Markets Policy EMEA at CFA Institute. He is responsible for developing research projects, policy papers, articles, and regulatory consultations that advance CFA Institute policy positions, focusing on market structure and wider financial market integrity issues.

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