Last week, the FCA published its report following its thematic review (TR16/5) on dark pools, called ‘UK equity market dark pools – Role, promotion and oversight in wholesale markets’.
Dark pools have existed in the UK wholesale equity market and elsewhere for over a decade and are organised systems for the trading of shares with no pre-trade transparency, where the price and volume of all orders are hidden and anonymous. Under the Markets in Financial Instruments Directive (‘MiFID’) they are regulated as either trading venues (such as multilateral trading facilities (‘MTFs’)) or as internal matching systems (such as broker crossing networks (‘BCNs’)).
Purpose and scope of the review
Public attention has turned increasingly to dark pools in terms of price transparency, perceived unfairness and the potential exploitation of some dark pool users (such as asset managers) by dark pool operators (such as investment banks) or more technologically advanced dark pool users.
The main focus of the review was to examine:
1.promotional activity undertaken by dark pool operators, in terms of actual delivery versus promotional materials provided; and
2.the quality of identification, management and disclosure of conflicts of interest by dark pool operators.
The review also covered governance, oversight, controls, and the possible impact on firms’ best execution obligations and on some of the infrastructure related to trading in dark pools.
The review’s findings are most relevant to asset managers, operators of BCNs and dark MTFs, and other wholesale market participants.
Overall, the FCA found that dark pool users welcomed the additional liquidity and reduced risk of information leakage offered by dark pools, as well as the potential pricing and costs benefits. Dark pool operators were also found to have responded to public concerns and regulatory interventions in the US and elsewhere - for example banks have addressed promotional activities and management of conflicts of interests around dark pools.
However, improvements need to be made by both users and operators to enhance due diligence, avoid conflicts of interest and improve best execution.
Next steps for firms
This thematic review, like others, is an indication of the FCA’s supervisory and enforcement priorities. It provides useful guidance on the regulator’s expectations, especially in the context of the FCA and PRA’s forthcoming implementation of MiFID II and Markets in Financial Instruments Regulation (detailed in the FCA’s CP16/19 and the PRA’s CP9/16), the FCA’s Thematic Review on Best Execution (TR14/13), and the general technological advances made in the equity markets.
To ensure good customer outcomes, firms should:
1.consider and demonstrate compliance with FCA Handbook requirements, for example, in terms of considering the Market Abuse Regulation which has now widened the scope of terms of instruments, venues and behaviours caught under the market abuse regime. Operators should also consider requirements to avoid conflicts of interest such as in terms of order queue prioritisation, order type restrictions etc.;
2. if regulated by both the FCA and PRA, and accessing dark pools via algorithmic trading services, be mindful of ensuring that their trading systems are resilient, can prevent erroneous orders being sent, and are subject to appropriate trading thresholds and limits; as the PRA has proposed creating a new Algorithmic Trading part of the PRA Rulebook to transpose the prudential requirements of MiFID II;
3.if they are dark pool users, be very clear about their rationale for using dark pools and conduct enough due diligence to properly understand the operating model of each dark pool they use, as no two dark pools are the same;
4.revise execution strategies and policies accordingly, in the case of dark pool users, to ensure compliance with best execution obligations to underlying clients, whilst operators should provide clear details about the design and operation of a dark pool, such as how orders are actually routed and executed;
5.remain alert as markets evolve and be vigilant about a potential adverse impact on fair and orderly markets, so that best execution remains an important responsibility for all firms;
6.in the case of operators, ensure that materials discussed with users are misunderstood and that key features offered by a BCN are comprehensive, clear, fair and not misleading;
7.do more, as operators, to improve the monitoring of their dark pools, especially in terms of operational integrity, best execution, client preferences and unwanted trading activity. Additionally, operators should improve governance and the strength of their second line of defence, so that the latter is thoroughly conversant with the complexities of electronic platforms, including dark pools and algorithms, and to enable robust challenge, guidance and support.
FCA’s next steps
The FCA will contact all users and operators who participated in its review on dark pools to remind them of their obligations, for example in terms of best execution, and to request action to be taken where required It will also actively monitor arrangements that investment managers have in place to ensure best execution and changes they have executed following the FCA’s review on best execution. We would advise firms to consider the FCA’s feedback and findings, and take any necessary action to comply with their regulatory obligations.