Shining a light into dark pools

The Financial Conduct Authority (FCA) has published the results of its Thematic Review into UK equity market dark pools. There is a broadly positive view of dark pools and their contribution to the market, although with a cautionary note sounded on management of conflict of interests and governance, complete with a list of 75 questions for users and operators of dark pools to use in a process of self-reflection.

What is a dark pool?

For the uninitiated, the term ‘dark pool’ immediately conjures up a sinister image – however, in reality, it is simply a term used for a trading venue without pre-trade transparency, such that all orders are anonymous and hidden as to price and volume.

Dark pools have existed and been regulated in the UK for over a decade; historically, they were most useful for institutional investors looking to execute large block trades in an anonymous and off-exchange manner so as to minimise price slippage. The FCA notes that this position has evolved with the ascent and ease of use of automated trading. There are two sides to any dark pool:

• Users – such as large asset management firms, insurance companies, hedge funds and HFTs. The FCA noted that nearly all users sampled participated in most, if not all, dark pools in the review.

• Operators – such as investment banks – with widely different operating models.

Dark pools have been a subject of increased public attention, following Michael Lewis's book Flash Boys, with concerns about lack of price transparency, perceived unfairness and potential exploitation of some unsophisticated users.

Overall findings

Despite that background, the FCA found that users were positive about the impact of dark pools – they welcomed the additional liquidity, increased potential for bid-offer spread capture and lower risks of information leakage, and could perceive the beneficial impact on pricing and cost.

The area was recognised as somewhat self-regulated – the FCA noted that dark pool operators had clearly responded to public concern and regulatory intervention with advancements in business model design, promotional materials and management of conflict of interest. Nevertheless, there were areas for improvement.

Development points for operators

The key message for operators: focus on effective management of conflicts of interest, both operator/client and intra-client. For example, the FCA noted that where bank operators allowed access for their own trading desks, their access could not be favoured over other third party participants. Similarly, a potential conflict of interest was identified where live or very recent order flow information in a dark pool was seen by trading desks or support staff in the firm. Controls around access for traders, trade support and second line of defence staff were not sufficiently robust: the FCA expressed surprise at the number of staff with access to order information.

In conjunction, operators must provide best execution. Smart order routing was another highlighted source of potential conflict. The FCA found that bank operators consistently routed orders to their own pools before routing elsewhere. While the FCA accepted this may be justified on the basis of optimised costs and reduced information leakage, it must also satisfy best execution criteria.

On marketing, the FCA emphasised that operators must provide clear detail to users as to the design and operation of their dark pool – in particular, interaction with their wider electronic platform. However, the FCA accepted that marketing materials had been updated following fines on this topic in other jurisdictions.

Finally, the FCA reiterated its strong focus on senior management and oversight. It identified a need to improve governance and second line of defence – particularly by ensuring those responsible had sufficient expertise to thoroughly understand the complexity of the electronic platforms and challenge the business on technical issues.

This is important for firms within scope of the Senior Managers and Certification Regime. Firms providing algorithmic trading/systems must allocate overall responsibility to a Senior Manager. The algorithmic trading function is one of the significant harm functions within the Certification Regime such that individuals performing this function must be certified as fit and proper at least annually.

Messages for users

Users are not left out of the FCA's reach: they are warned to consider clearly their rationale for using a dark pool, so as to ensure that they are acting in the best interest of their client when placing orders. Users must also conduct adequate due diligence to understand the operating model of a pool and monitor execution policy on an ongoing basis, to be certain they are meeting their own best execution obligations to their clients.

Where to from here?

The FCA's position on dark pool execution is generally is more conciliatory than in the U.S. – in part, due to the different regulatory structures defining best execution. The U.S. regulation on point (namely, Regulation NMS) focuses solely on price, whereas in the UK and the EU, best execution involves many factors of which price is only one.

The implementation of MiFID II from January 2018 is likely to have a significant impact on dark pools (and, at least for the moment, the FCA appears to expect firms to anticipate it will be implemented in the UK). Pending final rules, the extent to which dark pools will need to be restructured, and how, is as yet uncertain. Regardless of that, the FCA clearly expects all dark pool users and operators to carefully review the report, and the associated 75 targeted questions, and reflect on their own operations and practices.

More generally, the FCA notes that rapid technological advancement and innovation give rise to 'significant new conduct risks in wholesale equity markets'. It said to be a 'key managerial responsibility' to make an effort to apply lessons learnt in this sector to other products and markets: excuses based on the added complexity of ultra-fast processing speeds, intricate strategies and smart order routing are no defence.