For some participants, however, the infractions by dark pool operators were not the real surprise.
“What is shocking is that people have been shocked by some of the stories that have emerged about infractions at some dark pool providers,” says Lenzo.
Russell Investments and its transition management business utilises dark pools and other non-exchange execution venues as tools for liquidity and price discovery which, Lenzo says, are “not a placebo for the challenges in the lit market and exchanges”.
“There have been a lot of improprieties,” he says, “and they will keep coming. Exchanges have the benefit of a very defined and transparent rule set to which participants must adhere in the context of a lit market.”
APPROACH WITH CAUTION
With dark pools making headlines for the wrong reasons, investors are becoming more savvy to the dangers associated with these platforms. Although investors can enjoy significant savings using a dark pool to transact speedily and in size when they are carrying out a portfolio transition, for example, the infractions by dark pool operators mean they may still not be getting the best possible execution for their transition. If the impact of the dark pool operators’ activities create a market impact by altering the lit price, or by unfairly prioritising some customers in the trading line, that poses a risk for asset owners.
“Investors need to understand how to navigate them and who is operating them,” warns Campestre, “which is why proper due diligence and trade cost analysis is particularly important.”
Asset managers and transition managers are seeing an increasing number of clients asking questions about the detail of how they interact with dark pools as part of their due diligence. A couple of years ago this was much more limited.
“Clients want to see execution quality and to look at the drivers of best execution, including how we are interacting with dark pools,” Lenzo says. “Third party transaction cost analysis provides the proof that this is working well, and clients should be asking for that proof.”
Asset owners should also ensure those trading on their behalf are doing so with their eyes wide open. The high degree of opacity in dark pools means there is an even greater need to be informed and diligent about execution quality and analysis.
The key point is alignment of interests – making sure a dark pool operator is acting in the interests of the participants charged with managing assets, rather than trying to maximise its own trading revenue.
If investors want to ensure they are getting the best execution from those trading on their behalf, careful attention must be paid to how fund and transition managers are interacting with dark pools. Particularly in the world of transition management, where trade sizes can be very significant, the impact of using a dark pool that is not properly run can be meaningful.
How does someone using a dark pool protect themselves from these infractions? By assuming the pool is not, in fact, dark.
According to Russell Investments’ Lenzo: “You have to place orders in a manner that assumes people can see them to protect them from adverse price movements or gaming by other traders, or participants.”
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