Switzerland, 17th January 2017.
Off-exchange trading venues have been used for over ten years, yet there remain several assumptions about dark pools, along with high profile regulatory incidents, which have raised questions about the issue of Best Execution ahead of the implementation of MiFID II.
It is a widely held belief that trading in the dark entails no resultant market impact and no information leakage. While this does indeed hold true some of the time, it is not always the case. Furthermore, the SEC has levied around $100m in fines on several dark pool operators, raising questions as to whether Best Execution is always being achieved for those whose orders are routed to dark pools.
Primary exchanges and MTFs operate order books whose underlying mechanism is the continuous double auction that gives rise to the bid-ask spread. Since buyers (sellers) can only get an instant fill at the ask (bid), the spread is considered a transaction cost.
Dark pool operators aim to significantly reduce that part of the transaction cost attributed to the spread by offering buyers and sellers the opportunity (note opportunity - there’s no guarantee) to trade at the mid-price of the lit order book.
What is perhaps best known about dark pools is that they often see trades executed with much greater volume than what is available on the touch in the lit, while details of transactions are only made public after a trade has gone through.
Put simply, if your order gets fully filled in the dark, it means that there is at least the same sized order, if not bigger, on the other side. Whereas if you don’t get fully filled the other side of your trade knows you have bigger size than them. This is very valuable information to hold.
The other point here is less simple, yet arguably just as important. While difficult to confirm, it is possible that there could be information leakage from a trade if orders are consistently not being filled at the mid-price in a specific dark pool. Furthermore, even if orders are being consistently filled at the observed mid-price, subsequent price action against you could indicate that you have been getting fills from market makers who have spied an opportunity to unwind a substantial position more cheaply than they could do on the lit order book.
Both the above scenarios mean that, for any given order, you could be better off executing - passively or aggressively - on the lit order book rather than looking to trade at the mid price in a dark pool. This is further supported by the fact that MTFs will often reward passive order flow with rebates.
Ultimately, choosing the execution venue depends on rigorous analysis on a trade-by-trade basis, and this is something for which adaptive execution algorithms can be very useful.
Best execution is one of the central tenets of MiFID II (as it was with MiFID) and sell side firms will soon be required to take all sufficient (as opposed to reasonable) steps to ensure best execution is indeed achieved when executing orders on behalf of clients. But where a broker-dealer is also running a trading venue that is hungry for order flow, there is an inherent temptation for the operator to send the flow there first.
It is the job of the dark pool operator to show that, where it has touted the operations of its own order routers, those routers are acting wholly in the interests of best execution.
Exchanges and MTFs may be thought of as independent parties when it comes to running trading venues and independence is key to avoiding potential conflicts of interest that can be associated with broker-run dark pools. When it comes to smart order routing, truly independent execution algorithms have no pre-programmed interest in sending orders anywhere or in any form other than for best execution.
Can sell side firms that are obliged to route orders for best execution continue to operate their own dark pools and prove the same level of independence as the primaries and MTFs? Yes - by integrating independent, third party best execution technology within their own order and execution management systems (OMS/EMS).
Dark pools will continue to thrive, as they should do, as long as the lit markets exist. Market participants should be aware that sometimes it is better queueing in the lit order book to try and fill passively instead of simply paying away half of the spread. Furthermore, if and when the decision to trade at mid has been made, you then have to decide which dark venue is the best meeting place for you and your counterparty.
MiFID II raises the bar for Best Execution. In volatile and fragmented markets, the sell side cannot afford to have anything but the best, most robust and impartial trading tools and analytics to ensure Best Execution for their clients. It is at the heart of our mission at itarle to provide cutting edge technology that meets these needs.