The anonymous trading venues – which are run by exchanges, investment banks and brokers – are designed to help investors buy and sell large blocks of stock without showing their hands to the market. But they have attracted regulatory scrutiny across the globe, particularly in the US, because of perceived unfair access, inaccurate promotional materials and potential exploitation by more technologically savvy users.
The FCA met with several UK-based dark pools and buyside investors earlier this year to review potential conflicts of interests around the venues, which account for more than 10% of all European stock trading, according to analysts.
Here is what the FCA found during its review, which was designed to increase its knowledge of the sector, observe good and bad practice, and provide recommendations for future guidance.
Lessons for dark pool operators
For the uninitiated, European dark pools typically fall into one of two constructs: multilateral trading facilities, or MTFs, which have common rulebooks and are accessible to all; or broker crossing networks, or BCNs, which are unregulated and are operated by banks – including Morgan Stanley, UBS and Credit Suisse – with a high level of discretion.
The FCA met primarily with BCNs during its review, but also involved some MTFs. It found that most banks routed client orders to their own BCN as an initial step. The FCA said this may well be justifiable, but encouraged operators to regularly test its presumptions against best execution standards.
Overall, it found no widespread failure to comply with regulatory requirements, adding that controls around marketing materials had improved “following significant management attention” prompted by regulatory action in the US and elsewhere.
It did find room for improvement, however, particularly around processes for producing and distributing marketing materials, which “varied across the industry”. It also said monitoring needed to improve, adding that while most trading activity is now capable of being processed in millisecond (or faster) timeframes, “monitoring and oversight capability lags well behind”. The FCA noted controls were “weak” among some BCN operators.
The user experience
Overall, the FCA said users “welcomed the additional liquidity, lower risk of information leakage and the potentially beneficial effect on pricing and costs that dark pools offered”.
While the number of serious complaints about dark pools was very low, most users told the FCA they would not hesitate to switch off a venue if they became unhappy with the service or the quality of execution. This was experienced by Barclays, ITG and UBS when they disclosed fines relating to their US dark pools during 2014 and 2015.
However, the FCA found that some large investors had been reverting to more traditional trading strategies and were making “minimal use” of the venues. In some cases, it noted, investors had decided to “entirely shun the use” of dark pools.
The FCA said it was was apparent that some users of dark pools could take steps to “improve their own understanding of the various pools via better due diligence and the monitoring of their use of dark pools to ensure intended results are achieved”.
Many dark pool operators group users into one of several tiers, depending on their trading style and the infrastructure they use. These include tiers for high-frequency traders, in-house trading desks or brokers acting on behalf of institutional investors. This allows users to opt out of interacting with orders from certain tiers if they wish.
The FCA said this type of profiling varied from “very minimal” to “very detailed analysis of planned trading activity”. However, it said that updating these profiles “was not always done in a systematic manner”.
It also found that where clients did request to opt out of interaction with a certain tier of users, the collection and processing of this information was done in a “haphazard” way that was “difficult to audit and systematically weak across the industry”.
Unfair user access
It is not unusual for banks to allow in-house trading desks to access their dark pool, to help add a wide range of liquidity for clients. But there are FCA requirements that such desks are not given a favourable advantage over third-party participants.
The FCA found one example of an in-house trading desk being able to access its own BCN via a different infrastructure to that of clients, “which gave it a potential latency advantage constrained only by management controls”.
The regulator recommended that firms “review the set-up of their internal flows to their dark pools and periodically test for efficacy in relation to fair access”.
However, the FCA also found that some BCNs actually ensured institutional participants were given prioritisation for execution over ELPs [electronic liquidity providers, which are typically high-speed trading firms]. “The intent is to counter the technological advantage that ELPs may have, as well as the opportunistic trading activity of some ELPs”.
The FCA found that access to trading and order information within dark pools was typically restricted to limited number of front office, electronic trading staff, as well as a dedicated compliance team. However, it also found incidences where controls over access restrictions were weak.
In particular, there was retained access to dark pool data by IT support staff long after completion of the IT work; as well as continued access by former trading staff who had moved to a different role within the bank.
The FCA said the number of staff granted access varied significantly from one dark pool to another, with one firm’s permitted tally running into the hundreds. The FCA added: “We would expect firms with larger numbers of staff or support specialists to consider whether the access currently afforded to staff is critical to the performance of their roles.”
Wide range of models including speed bumps
The FCA said it uncovered a wide range of dark pool models, ranging “from very basic models with open membership and the presence of aggressive traders to sophisticated offerings with tightly controlled membership and closely monitored activity”.
In particular, it said it found evidence of “speed bumps” at some dark pools – a mechanism made popular by IEX Group in the US to slow down incoming orders to help level the playing field for certain investors.
The FCA said “speed bumps” had been introduced by some operators to “ensure that all participants have equalised access in terms of messaging speed”. However, it warned that these “should be monitored to ensure that, following changes to the platform of any kind, the speed bump does not inadvertently introduce a benefit for a participant or a class of participants”.
It also said some dark pools could devote attention to their capacity, to ensure their systems and controls are sufficiently robust.
Additional reporting by Sam Agini