Views on improving the integrity of global capital markets
30 September 2015

Investors Beware: New Dark Pools Report Issues Warning

Posted In: Market Structure

It has been a while since I last wrote about dark pools. However, Healthy Markets has released its report on recent regulatory actions against dark pools titled The Dark Side of the Pools: What Investors Should Learn from Regulators’ Actions. It aims to give investors a summary of recent dark pool misconduct as well as provide suggestions for trading in the modern market environment.

The report highlights three main cases of misconduct by dark pools: Pipeline, UBS, and ITG. All three cases broadly involved the dark pool misleading customers into thinking they were executing on a ‘safe’ venue while in reality they were being taken advantage of either by the sponsor’s own trading desk or predatory high-frequency traders (HFTs) that were allowed to operate in the dark pool. UBS even violated Rule 612 by accepting orders in sub-penny increments. Note that while price improvement in sub-penny increments allows orders to be executed off-exchange at prices nominally better than the National Best Bid and Offer (NBBO), it is illegal to request sub-penny prices when posting the orders in the first place.

The conclusions drawn by the report are sobering:

  • Regulatory cases against UBS, Barclays, and Credit Suisse show that no firm is a priori above wrongdoing.
  • Misconduct may last for years and, once discovered, often thanks only to whistle-blowers, regulatory action/enforcement may take years longer.

Particularly startling are the statistics relating to brokers routing orders to their own dark pools. For example, Credit Suisse is listed as having 7% share of market trading in Q1 2015 and its dark pool 1.6% market share. Yet, Credit Suisse’s fill rates in its own dark pool are around 30%.

At the end of the report, Healthy Markets advises investors to watch out for their own interests and not simply trust brand names or promises. The report is not optimistic about regulatory reforms being suitably timely or effective to help protect investors and recommends investors themselves:

  • Demand more disclosure information from dark pools.
  • Try to avoid and mitigate conflicts of interest in dark pools, particularly in cases where an affiliate of the dark pool trades for profit on that venue.
  • Modernize their own practices for determining whether best execution is being achieved.
  • Reward more transparent and less-conflicted venues with order flow.

CFA Institute has published several pieces on dark pools, in particular the 2012 report on Dark Pools, Internalization, and Equity Market Quality. Our position, derived from the 2012 research, is that dark pools have had a beneficial impact on market quality but that beyond a certain point in terms of market share, it is likely that these benefits are reduced or even reversed. Further, we have called for more voluntary transparency from dark pools about their operating mechanics, something echoed by Healthy Markets.

Healthy Markets’ report recommendations for investors to vigilantly look after their own interests is something CFA Institute agrees with although we also believe that regulatory pressure must be brought to bear on improved disclosure requirements and conflicts of interest. If regulatory action is considered to be slow and ineffective, this should spur greater engagement with regulators on the issue.

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Image Credit: RomoloTavani

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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