FCA Thematic Review16/5: UK Equity Market Dark Pools – Role, Promotion and Oversight in Wholesale Markets
Senior managers at users and operators of UK equity market dark pools need to ask themselves and their staff specific questions about potential conduct risks that the pools pose, the Financial Conduct Authority has said.
In a thematic review(PDF) based on meetings with asset managers and other users of equity dark pools, operators of dark broker crossing networks (BCNs) and multilateral trading facilities (MTFs), and other unlit UK equity market participants, the FCA suggested 25 questions for users, relating to the value and purpose of dark pools, pool sign-up and due diligence standards, and users' monitoring of their own dark pool activity and best execution.
It set out 50 questions for dark pool operators: in relation to the material they used to market their pools and electronic offerings; client onboarding; operational design and integrity; monitoring activity in their pool(s); confidentiality of data and dark trading information; conflicts of interest and register; governance and the lines of defence. (The full list of 75 questions is set out on pages 52-57 of the thematic review.)
The British regulator found that users were not concerned by the lack of pre-trade transparency that characterizes dark pools, and that they generally welcomed the additional liquidity, lower risk of information leakage on their trading activity, and the beneficial impact potential on pricing and costs that unlit venues offered.
The regulator also found that the operators of UK equity dark pools have moved to meet public and regulatory concerns about how they work, by redesigning business models, revising marketing claims about the benefits of electronic and algorithmic trading, and improving their management of conflicts of interests. The latter can arise between operator and client and/or between different clients or client types, such as institutional clients versus high frequency traders (HFTs) and other external liquidity providers.
"While we did not observe a failure to comply with regulatory requirements, we did identify a number of areas where improvement is required," the FCA said, listing the key messages of its review as:
"Operators need to provide clear detail as to the design and operation of a dark pool – particularly how it interacts with other activities on the operator’s wider electronic trading platform. As no two pools are exactly alike, operators should ensure that disclosure or distributed materials on the services, key features and/or options offered by an internal crossing network are comprehensive, clear, fair and not misleading, and engage in discussions with users/clients to ensure that these materials are understood.
"Operators should improve the monitoring of their pool(s) – in particular, operational integrity (accuracy of reference pricing, capacity, stability), best execution (where applicable), client preferences, and unwanted trading activity. The review and reporting on trading activity in a pool should reflect the relative sophistication and complexity of the features offered. The onus is on the operator to have adequate controls and oversight to ensure that all services, features and/or options made available to users consistently operate as designed and intended.
"Operators should do more to identify and manage conflicts of interest, including both client vs. client and operator vs. client. The mitigation steps taken such as membership controls, order queue prioritisation, order type restrictions, structural controls (e.g. speed bumps) and policies and procedures can be strengthened and independent assessments can be regularly refreshed. This is especially important as many operators offer access to a dark pool as a standard component of a wider brokerage agreement and as an integral component of an electronic trading platform.
"Users should be clear about their rationale for using or not using dark pools (why, how and when). It is very important that users conduct adequate due diligence to thoroughly understand the operating model of a pool before commencing trading activity and be able to monitor ongoing activity and outcomes directly attributable to their use of a dark pool.
"Operators should improve governance and the strength of the second line of defence, which was weaker than expected. Some firms had made good use of recently upgraded best execution infrastructure for oversight of dark pools. However, the second line of defence should have sufficient expertise to thoroughly understand the complexities of the electronic platform including the dark pools, and to enable robust challenge, guidance and support.
"Users and operators should remain alert as markets evolve. Infrastructure changes at the firm or industry level, the emergence of new participants and the shift of technological advantage among participants can give rise to significant new risks. Vigilance regarding a potential adverse impact on fair and orderly markets and best execution (where applicable) remains an important responsibility for all firms.
"Users and operators should carefully consider the new MiFID II rules and the impact on existing and planned business models. Continuing attention should be paid to the ongoing detailed discussions on systematic internalisers and the rules that will apply, particularly in regard to matched principal trading. Much financial regulation currently applicable in the UK derives from EU legislation. This regulation will remain applicable until any changes are made, which will be a matter for Government and Parliament. Firms must continue to abide by their obligations under UK law, including those derived from EU law and continue with implementation plans for legislation that is still to come into effect. The longer term impacts of the referendum decision to leave the EU on the overall regulatory framework for the UK will depend, in part, on the relationship that the UK seeks with the EU in the future."
Additionally, the FCA reminded market participants that best execution obligations, where applicable, were an important market conduct safeguard and pointed out that no users or relevant operators were exempted from them through the use of order routing, algorithms, or trading at ultra-fast speeds, whether on lit or dark markets, internal networks or other third-party venues.
"We encourage operators of electronic trading platforms including dark pools and smart order router service providers to engage with users and provide requested information on how orders are actually routed and executed, as well as statistical information on activity within their respective pool(s) – ideally with reference to, at least, millisecond clock speeds," the regulator said.
In a thematic review(PDF) based on meetings with asset managers and other users of equity dark pools, operators of dark broker crossing networks (BCNs) and multilateral trading facilities (MTFs), and other unlit UK equity market participants, the FCA suggested 25 questions for users, relating to the value and purpose of dark pools, pool sign-up and due diligence standards, and users' monitoring of their own dark pool activity and best execution.
It set out 50 questions for dark pool operators: in relation to the material they used to market their pools and electronic offerings; client onboarding; operational design and integrity; monitoring activity in their pool(s); confidentiality of data and dark trading information; conflicts of interest and register; governance and the lines of defence. (The full list of 75 questions is set out on pages 52-57 of the thematic review.)
The British regulator found that users were not concerned by the lack of pre-trade transparency that characterizes dark pools, and that they generally welcomed the additional liquidity, lower risk of information leakage on their trading activity, and the beneficial impact potential on pricing and costs that unlit venues offered.
The regulator also found that the operators of UK equity dark pools have moved to meet public and regulatory concerns about how they work, by redesigning business models, revising marketing claims about the benefits of electronic and algorithmic trading, and improving their management of conflicts of interests. The latter can arise between operator and client and/or between different clients or client types, such as institutional clients versus high frequency traders (HFTs) and other external liquidity providers.
"While we did not observe a failure to comply with regulatory requirements, we did identify a number of areas where improvement is required," the FCA said, listing the key messages of its review as:
"Operators need to provide clear detail as to the design and operation of a dark pool – particularly how it interacts with other activities on the operator’s wider electronic trading platform. As no two pools are exactly alike, operators should ensure that disclosure or distributed materials on the services, key features and/or options offered by an internal crossing network are comprehensive, clear, fair and not misleading, and engage in discussions with users/clients to ensure that these materials are understood.
"Operators should improve the monitoring of their pool(s) – in particular, operational integrity (accuracy of reference pricing, capacity, stability), best execution (where applicable), client preferences, and unwanted trading activity. The review and reporting on trading activity in a pool should reflect the relative sophistication and complexity of the features offered. The onus is on the operator to have adequate controls and oversight to ensure that all services, features and/or options made available to users consistently operate as designed and intended.
"Operators should do more to identify and manage conflicts of interest, including both client vs. client and operator vs. client. The mitigation steps taken such as membership controls, order queue prioritisation, order type restrictions, structural controls (e.g. speed bumps) and policies and procedures can be strengthened and independent assessments can be regularly refreshed. This is especially important as many operators offer access to a dark pool as a standard component of a wider brokerage agreement and as an integral component of an electronic trading platform.
"Users should be clear about their rationale for using or not using dark pools (why, how and when). It is very important that users conduct adequate due diligence to thoroughly understand the operating model of a pool before commencing trading activity and be able to monitor ongoing activity and outcomes directly attributable to their use of a dark pool.
"Operators should improve governance and the strength of the second line of defence, which was weaker than expected. Some firms had made good use of recently upgraded best execution infrastructure for oversight of dark pools. However, the second line of defence should have sufficient expertise to thoroughly understand the complexities of the electronic platform including the dark pools, and to enable robust challenge, guidance and support.
"Users and operators should remain alert as markets evolve. Infrastructure changes at the firm or industry level, the emergence of new participants and the shift of technological advantage among participants can give rise to significant new risks. Vigilance regarding a potential adverse impact on fair and orderly markets and best execution (where applicable) remains an important responsibility for all firms.
"Users and operators should carefully consider the new MiFID II rules and the impact on existing and planned business models. Continuing attention should be paid to the ongoing detailed discussions on systematic internalisers and the rules that will apply, particularly in regard to matched principal trading. Much financial regulation currently applicable in the UK derives from EU legislation. This regulation will remain applicable until any changes are made, which will be a matter for Government and Parliament. Firms must continue to abide by their obligations under UK law, including those derived from EU law and continue with implementation plans for legislation that is still to come into effect. The longer term impacts of the referendum decision to leave the EU on the overall regulatory framework for the UK will depend, in part, on the relationship that the UK seeks with the EU in the future."
Additionally, the FCA reminded market participants that best execution obligations, where applicable, were an important market conduct safeguard and pointed out that no users or relevant operators were exempted from them through the use of order routing, algorithms, or trading at ultra-fast speeds, whether on lit or dark markets, internal networks or other third-party venues.
"We encourage operators of electronic trading platforms including dark pools and smart order router service providers to engage with users and provide requested information on how orders are actually routed and executed, as well as statistical information on activity within their respective pool(s) – ideally with reference to, at least, millisecond clock speeds," the regulator said.
Peter Elstob is senior editor, securities and markets, UK and Europe, at Thomson Reuters