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Clearing Amp Settlement
Big bourses take on dark pool competitors
From the Financial Times of Sun, 09 Nov 2014 15:38:09 GMT

The London Stock Exchange is planning a high-noon equities shootout, and dark pools – sophisticated trading venues run mostly by banks and brokers – are in the line of fire. The LSE is to launch intraday auctions as a means of wresting back business from dark pools, amid deepening controversy over the high-tech interlopers. But will the innovation catch on? And is it good for investors?

“It sounds great. We should do [an intraday auction] here,” said a blue-jacketed market-maker at the New York Stock Exchange. “I’m in favour of anything that brings business to lit exchanges and away from dark pools. To me, dark pools are the bad guys.”

He would say that. The NYSE still competes with the dark pools, through its popular opening and closing auctions. Since 2000, the LSE, too, has bookended its own trading day in the same way.

But dark pools – where prices and order sizes are disclosed only after transactions close, to avoid moving prices on conventional “lit” bourses – have been in the ascendancy for some time. Any large investor with a chunky buy or sell order to execute may prefer a dark pool over a traditional exchange transaction. Between 6 and 10 per cent of UK equities by value are now traded in the shadows, compared with about 15 per cent for US stocks.

At the same time, though, the credibility of dark pools – operated by banks, brokers and exchange companies – has been damaged. Michael Lewis’s polemic book Flash Boys alleged some high-speed traders divine what orders big investors are routing through dark pools and profit accordingly.

Eric Schneiderman, New York attorney-general, has accused Barclays of lying to investors in marketing materials about the protection available from flash traders in one US dark pool. The bank has denied the allegation.

Regulators on both sides of the Atlantic have dark pools in their sights. The EU plans complex limits. Critics say these could result in one-third of FTSE 350 stocks being temporarily excluded from dark pools when traded in smaller amounts.

The LSE’s new midday auction, which would begin late next year, is a response to the reform, due for introduction in 2017. “We recognise the market needs a better way of trading blocks,” says Brian Schwieger, head of equities at the exchange.

Auctions which bunch and delay individual buy and sell orders should help to hide sensitive investor information – but without the scope for real-time flash-trader manipulation that could plague dark pools.

The LSE has hedged its bets. It has shown no ideological objection to dark pools, a business in which its own Turquoise subsidiary competes.

But it does not want to be left behind in the auctions business. Deutsche Börse, a one-time bidder for LSE, already operates a popular intraday stock auction, with which the LSE’s own two-minute session would coincide.

Larry Tabb, chief executive of Tabb Group, a US markets consultancy, acknowledges that intraday auctions could theoretically supplant dark pools. But he questions their ability to do so without supporting legislation. “Platforms that have tried to have intraday auctions have not pulled it off,” he says. The market share of dark pools has been rising in the US, he notes, despite Flash Boys.

Mr Tabb attributes this in part to falling brokerage commissions, which intermediaries have been unable to limit by pushing down costs on lit exchanges. His remark identifies a central, worrying ambiguity of proliferating dark pools. Brokers and investment banks have always matched some big orders off-exchange. Dark pools were a natural extension. The question is whether they have evolved to serve intermediaries and specialist traders rather than long-term investors.

Investors should favour big, transparent exchanges run by specialists, rather than trading venues managed by banks and brokers with conflicts of interest

This risk is most acute in the US. Data from Finra, an independent securities regulator, shows the most liquid US stocks are traded on 43 “alternative trading systems”. Most of them are dark pools run by groups such as Credit Suisse, Deutsche Bank and Morgan Stanley. Liquidity has fragmented as a result of US laws requiring exchanges to route orders to rivals offering the best price.

Dark pools are not bad in the bone. Lit exchanges have their own history of abuses. However, the proliferation and elaboration of dark pools creates dangers regulators and investors are right to fear. The harder it is for mainstream fund managers to understand dark pools, the greater the power of experts to run rings around them. Intermediaries create complexity in financial markets from self-interest, as well as a desire to help clients.

The EU reform is clumsy in design but sensible in intention. Regulators must balance principles such as best-price execution against the need for simplicity. Investors should favour big, transparent exchanges run by specialists, rather than trading venues managed by banks and brokers with conflicts of interest with which to wrestle. Stock auctions are worthy of their support.

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