In a paper published last week by the Financial Conduct Authority (FCA), a group of academics have warned that dark pools, or anonymous trading platforms, could damage the UK’s equity market if the value of its orders exceeds 17 percent of total activity across all stock exchanges and lit trading venues.
The study, however, stopped short of proposing major changes ahead of tougher MiFID II rules which take effect in January next year. The EU’s revised securities rules curb on the volume of dark pool trading and prohibits activity in such venues to exceed eight percent for each stock.
In addition, the academics said that tougher EU rules in 2018 could eliminate the benefits of trading in dark pools. In particular, they help institutional investors, like pension funds and asset managers, to protect themselves when they trade large blocks of stocks by withholding key details and thus don’t allow the market to move against them.
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In their paper, the academics found that that current levels of dark trading in London are not viewed as a significant concern as long as dark pools, which rely directly on prices occurring in the regulated markets, remain relatively small versus those of lit markets. They noted the quality of the market starts to deteriorate and that they distort market pricing and disadvantage traditional investors when they reach between 11 percent and 17 percent of overall trading.
Dark pools have attracted increasing scrutiny in recent years, amid warnings by exchanges and lobby groups about the lack of pre-trade transparency, perceived unfairness and the potential exploitation of some dark pool users.
The authors wrote in the paper published on Tuesday: “It would be reasonable to expect that when even informed traders start to trade in dark pools, or dark trading passes a certain threshold, market quality will be harmed. So it makes sense, in theory, that dark trading is beneficial only up to a point.”
They added: “It is important that policymakers take care not to eliminate the market quality benefits of dark trading by arbitrarily imposing uniform dark trading restrictions for all stock sizes. The latter aim is furthered by the existence of dark pools operating alongside lit exchanges,” the paper said. “It is important that policy-makers take care not to eliminate the market quality benefits of dark trading by arbitrarily imposing uniform dark trading restrictions for all stock sizes.”