Analysis: After this week’s fines for Barclays and Credit Suisse, new technologies should make capital market dark pools more visible.
Dark pool trading is once again high on the agenda, in light of the large fines handed out to Barclays and Credit Suisse related to their lack of transparency in the practice.
Barclays admitted misleading investors and breaking securities law in the US, and will pay fines reaching $70m to the Securities and Exchange Commission (SEC) and the New York Attorney General. Credit Suisse will pay a total out of $60m. These were the largest ever fines handed out for dark pool trading violations.
Dark pools are legal. They allow shares to be traded without the price being public, and buy and sell orders are not published as they are in a regulated exchange.
In some ways, technology lies at the heart of dark pool trading, and has driven its development. It was partly introduced to avoid computers trading at ultra high speeds as soon as certain conditions are met.
This allows firms using algorithmic trading platforms to buy shares that are the subject of a large order, before the price goes up after the block trade, allowing them to sell them on at a profit.
In dark trading orders are private within financial institutions, and neither humans nor computers who are not directly involved in the transaction can see orders that have been placed. This makes it harder for the algorithms cannot cash in.
It is also designed to avoid market destabilisation if large investors, such as pension funds, sell a large block of one particular stock.
"Algorithmic trading is one of the reasons why certain trades have to happen in the dark," Silvano Stagni, Global Head of Research at capital markets specialists Hatstand, told CBR.
"The moment you announce a big chunk of shares being sold or bought, even before the trade happens, before the order is put in the electronic exchange, the order is sent, the algorithm will pick it and act accordingly and therefore amplify the destabilisation," he said
Stagni said that the recent fines are not connected to technology, but there are regulatory changes afoot that will attempt to make dark trading more transparent. He says that these could have a knock on effect on technological innovation.
The big change is the updated version of the EU’s Markets in Financial Instruments Directive (MIFID), which regulates firms that provide services to clients that are linked to ‘financial instruments’. The regulations call for greater transparency.
The London Stock Exchange Group explains that the legislation brings in Organised Trading Facilities are being introduced by the legislation. It said "they are designed as a ‘catch-all’. They aim to ensure maximum price transparency, reducing the amount of trading in dark pools."
Stagni said that reducing dark pools has indeed been a key European concern: "In Europe the emphasis in the review of MIFID and other things is transparency and therefore the big bad wolf is dark trading," he said.
He said that the changes coming in, which are known as MIFID II and currently delayed, will mean that instead of operating within institutions, dark pool trading will have to take place within an exchange. Trades will have to be published, even if there is some kind of delay involved in order to avoid the kind of issue outlined above.
"That is what will bring in a shift with technology…later they will have to publish, they will have to inform, technology will also be geared to capture certain information and also the fact that at the moment they happen within the environment of a financial institution, later they will have to happen within the environment of an exchange," said Stagni.
This move to an exchange based model will alter the business model of dark pool operators, and they will have to have the right IT infrastructure behind it."Technology will have to support a completely different business model. It’s one of the subtler challenges with MIFID II. Things will not be the way they are now, so there is a huge change in technology that has to happen," said Stagni.
Ralph Silva, a banking analyst and managing director at SRN, agrees that the regulatory change will drive technological change, as dark pool transactions will have to happen faster as they become more transparent to avoid being undercut. "Anyone with a reasonable algorithm can see when a dark pool transaction is going through, and of course a dark pool transaction can take several hours, even several days depend on the size of it," he told CBR.
"The first thing I think is going to happen is latency is all but going to disappear. Most investment banks have very good latency, but there nowhere the theoretical minimum. There is a lot of improvement to be done, things as simple as network cards need to evolve. There’s a lot of things that need to happen so that when a dark pool transaction happens nobody has a chance to get underneath the transaction," he said.
As well as transparency, the changes could drive innovative change and competiveness, he said: "When does competitive advantage start, and transparency start? "That line in between the two gets very very shaded because in essence a dark pool is supposed to remove the competition element."
Silva also feels that the size of the recent fines, and the reasoning behind them, demonstrate that the regulators are demanding more data, and demanding it fast. "The big data elements, which have largely been ignored in dark pool trading typical because it typically slows the process down, I think that’s going to come back into it," he said. "Every move that happens within the transaction will be recorded."
Given the scale of those fines dished out to Barclays and Credit Suisse, the banks may decide money is better invested in a good big data system to record trades in the dark pool environment. This, said Silva, could be good news for the providers of such solutions.
"The enterprise technology providers have incredible solutions within this environment, they’ve had trouble selling. And all of a sudden we have a fine that says to the banks hold I don’t think we can build this stuff, I think we’re going to have to buy this stuff, so I think one of the true winners in this particular environment is going to be the enterprise vendors," he said.
Often it is technological innovation that drives regulatory change. There are multiple examples of this in the consumer technology space, such as Uber and encrypted messaging apps.
In the case of dark pool trading, the reverse is happening, and regulatory action, as well as imminent regulatory change, could promote technological innovation.