Dark Pools: Sink or Swim?

By Elizabeth Harrin (London)

The verdict has long been out on whether dark pools of liquidity improve the investment process, but the fluctuations in the market this year have certainly seen these trading systems gaining plenty of column inches. Are dark pool investments taking market share from traditional exchanges? Or are their trades falling off, as a result of economic slowdown? I’ve read commentators who argue for both sides, but dark pools can’t be doing well and failing, can they?

Dark pools are off-exchange electronic trading venues. They are also known as ‘alternative trading systems’ and they work by allowing large blocks of shares to be traded outside of the normal exchange, and with greater ease. Dark pools have been particularly successful in partnering with hedge funds as the prices aren’t public. Cloaked in secrecy, and yet a very obvious form of liquidity, dark pool prices are only published publicly once the trade is done.

Dark pools have been around in the US since the mid-1980’s. However, they haven’t gained in popularity until more recently. While exchange transactions tend towards smaller deals, dark pools have huge liquidity to be tapped and became very popular with institutional investors during 2007 and 2008. This year, though, the story has been more up and down.

Dark pools have come under scrutiny from the highest levels on both sides of the Atlantic recently. Chairman of the US Securities and Exchange Commission, Mary Schapiro, announced an investigation this summer, citing the “emerging risks” posed by dark pool activity.

“We have heard concerns from market participants that the lack of post-trade transparency by dark pools makes it difficult, if not impossible, for the public to assess dark pool trading and to identify pools that are most active in particular stocks,” she said. “This lack of transparency has the potential to undermine public confidence in the equity markets, particularly if the volume of trading activity in dark pools increases substantially. For example, the lack of reliable information can prompt speculation and suspicion about the basis for market fluctuations.” The European Commission is going to do the same, when it reviews the Markets in Financial Instruments directive later this year.

Dark pool operators have not in general opposed the SEC’s initiative, and most appear to be in favour of more transparency. However, when Nasdaq CEO Bob Greifeld called for an end to all forms of dark liquidity there was a small ripple of backlash from the alternative trading system community: dark pools offer access to liquidity that isn’t possible through other means, and there are good reasons for keeping this part of the market operational, even if regulated.

Despite the fallout from the economic crisis that has prompted a review of dark pool investments, and a general slowing down of trade, some dark pools are doing well. BATS Europe had its second best month ever in July, and launched a new dark pool in August, the first of its kind in Europe. The new trading platform will rebate 0.1 basis points to participants that add liquidity and charge 0.25 basis points to remove liquidity in the dark pool. The new dark pool is separate from BATS Europe’s current integrated book, which combines visible and hidden order types. BATS Europe participants can send orders to the dark pool using existing handlers with orders hidden and executed at the midpoint of the best bid and offer on the primary market. The launch of this pool takes the number of alternative trading systems in Europe to thirteen: let’s hope it’s not unlucky for the investors taking the plunge with BATS Europe.

With developments like this underway, it’s difficult to get a handle on where the dark pool trend is going. Investment Technology Group’s quarterly alternative trading system analysis shows that the second quarter of 2009 was particularly strong, with 13.8% of the Canadian market volume. Canada could be a potential hotspot for dark pools, as the post-trade reporting requirement there means that some of the concerns in the US market are irrelevant north of the border.

Institutional Investor has reported this year that dark pool activity is slowing down, although by next year dark pools will account for 15 percent of all US equity trades. Rosenblatt Securities report that in June, the share of US equity trading executed by dark pools increased – the alternative investment system marketplace isn’t slowing particularly at all. Rosenblatt analysts track 16 pools and saw them execute 7.82% of consolidated US equity volume that month.

The truth of the matter is that the market is in so much flux that dark pool activities are flourishing and contracting, depending on which month you read the analysis of trading volumes for, which market place, which country. There isn’t an easily identifiable global trend. For institutional investors looking to work out where dark pools are headed, things might be clearer after the SEC and European Commission reviews. Then at least we will know where we stand with change in regulation – if any will be forthcoming.