“Trading 900 shares even in a large cap company could potentially move a lit market, and create signal or footprint,” says Jason Lenzo, head of equity and fixed income trading for Russell Investments globally. “For example, we may make the decision to take 1,000 shares of a company to the market, and at the point where we send to execute, the order is sweeping through all possible venues and crossing networks on the way to the exchange. In this example, we may find 700 shares across various venues and crossing networks at midpoint, and only post 300 shares on the exchange. The benefit to the client is the 700 shares are done at midpoint, and the 300 shares on the exchange lessens any footprint or signal that may be inferred.
“But you could potentially find a block of 10,000 shares through a dark pool so you have the benefit of trading with no impact, while minimising spread erosion, signal risk and opportunity cost,” Lenzo adds.
Over the course of a transition, the benefit of using dark pools can be “multiple basis points in savings”, according to Russell Investments’ director, transition management – EMEA, Mirjam Klijnsma. “It can be 10-15 basis points or as much as 50-plus basis points because you’re trading at the mid-price and also reducing the market impact of the trade, which can in itself be well north of 25 basis points in our experience. Trading large blocks in a short time also minimises opportunity cost risk, which is much harder to quantify. Dark pools allow transitions to be implemented in a much shorter time versus only using the lit market.”
Trading at the ‘mid-price’, which sits at the heart of why dark pools can mean significant cost savings on sizeable trades, effectively means trades are conducted at the mid point between the bid and offer prices. As such participants, whether buying or selling, are only paying half the spread.
NO PANACEA
But while their importance cannot be overlooked for the efficient implementation of institutional asset owners’ asset allocation strategies, dark pools are not without their pitfalls. Many participants have been shocked by stories of dark pool operators being fined for acting inappropriately.
Michael Lewis’s book Flash Boys helped focus attention on the space, which has seen some of its largest players fall fowl of the regulators as the scale of fines rapidly escalates.
In August one of the largest operators, Investment Technology Group (ITG), was fined a record $20.3m, the largest fine handed out to a dark pool operator by the US Securities and Exchange Commission (SEC), following allegations it failed to disclose information to participants of its dark pool. The firm provides trading technology to asset managers, giving it access to those managers’ order books. The SEC’s charges centred on allegations ITG was a proprietary trader despite claiming to be ‘agency only’ and that it used confidential trading information without disclosing that to its clients.
Project Omega, as ITG’s secret trading desk was known, used the information from orders placed in its dark pool to earn a spread by making similar trades in lit markets before closing the position on its own pool. It is alleged to have earned over $2m trading 262 million shares in this manner.
ITG’s fine smashed the previous record $14.4m fine handed to UBS in January after it was alleged to have secretly and unlawfully allowed some customers to submit orders in increments smaller than a penny, pushing them to the front of the trading line.
And, as ITG’s fine was making headlines, rumours were already spreading of further potentially record-breaking settlements for alleged infractions, this time against Credit Suisse and Barclays, two of the biggest dark pool operators.
In March, the UK’s FCA announced it too would be investigating conflicts of interest in dark pools.
According to Urs Widmer, chief operating officer at SIX Swiss Exchange: “Currently, there is some noise about dark pools being leveraged for their owners’ benefit, such as brokers using the information they get from the pools they operate to profit for their own trading. It is important to look carefully at who owns these pools: independent market operators without their own trading will not have such a conflict.”
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