Following a survey the UK equity marketplace, focusing on dark pools and broker crossing networks, by examining promotional activity and the identification and management of conflicts of interest by dark pool operators, the FCA today published its Thematic Review TR16/5 “UK equity market dark pools – Role, promotion and oversight in wholesale markets”.
The FCA has conducted the report with a view to one of the work streams underpinning the ‘Wholesale financial markets’ priority theme in its Business Plan 2016/17.
Equity market dark pools have existed for well over a decade, and are subject to a regulatory framework in the UK that places clear requirements on users and operators of these services. However, dark pools have recently gained increased public attention in respect of price transparency, perceived unfairness and the potential exploitation of some dark pool users by dark pool operators or other more technologically advanced dark pool users. Part of the adverse publicity may reflect a lack of familiarity with regulation, how the markets involved actually function and the assumption that all dark pools are the same. This review explores and seeks to address specific concerns that have been raised in relation to dark pools in the UK equity market.
The FCA examined the promotion undertaken by dark pool operators, where it sought to assess actual delivery versus promises and/or promotional materials proffered; and the quality of the identification, management and disclosure of conflicts of interest by pool operators. In the course of its work, the authors also reviewed relevant governance, oversight and controls. While not a primary focus, the FCA also comments on the possible impact on firms’ best execution obligations, where relevant, and on some of the infrastructure related to trading in dark pools including smart order routing, crossing logic and technological resilience.
The findings and key messages in this report are most pertinent to wholesale market participants, including asset managers, the operators of broker crossing networks and dark multilateral trading facilities, and other firms operating trading venues and exchanges. The report may also be of interest to institutional and individual investors.
The report provides 7 key messages based on the FCA’s observations:
- Operators need to provide clear detail as to the design and operation of a dark pool – particularly how it interacts with other activities on the operator’s wider electronic trading platform. As no two pools are exactly alike, operators should ensure that disclosure or distributed materials on the services, key features and/or options offered by an internal crossing network are comprehensive, clear, fair and not misleading, and engage in discussions with users/clients to ensure that these materials are understood.
- Operators should improve the monitoring of their pool(s) – in particular, operational integrity (accuracy of reference pricing, capacity, stability), best execution (where applicable), client preferences, and unwanted trading activity. The review and reporting on trading activity in a pool should reflect the relative sophistication and complexity of the features offered. The onus is on the operator to have adequate controls and oversight to ensure that all services, features and/or options made available to users consistently operate as designed and intended.
- Operators should do more to identify and manage conflicts of interest, including both client vs. client and operator vs. client. The mitigation steps taken such as membership controls, order queue prioritisation, order type restrictions, structural controls (e.g. speed bumps) and policies and procedures can be strengthened and independent assessments can be regularly refreshed. This is especially important as many operators offer access to a dark pool as a standard component of a wider brokerage agreement and as an integral component of an electronic trading platform.
- Users should be clear about their rationale for using or not using dark pools (why, how and when). It is very important that users conduct adequate due diligence to thoroughly understand the operating model of a pool before commencing trading activity and be able to monitor ongoing activity and outcomes directly attributable to their use of a dark pool.
- Operators should improve governance and the strength of the second line of defence, which was weaker than expected. Some firms had made good use of recently upgraded best execution infrastructure for oversight of dark pools. However, the second line of defence should have sufficient expertise to thoroughly understand the complexities of the electronic platform including the dark pools, and to enable robust challenge, guidance and support.
- Users and operators should remain alert as markets evolve. Infrastructure changes at the firm or industry level, the emergence of new participants and the shift of technological advantage among participants can give rise to significant new risks. Vigilance regarding a potential adverse impact on fair and orderly markets and best execution (where applicable) remains an important responsibility for all firms.
- Users and operators should carefully consider the new MiFID II rules and the impact on existing and planned business models. Continuing attention should be paid to the ongoing detailed discussions on systematic internalisers and the rules that will apply, particularly in regard to matched principal trading. Much financial regulation currently applicable in the UK derives from EU legislation. This regulation will remain applicable until any changes are made, which will be a matter for Government and Parliament. Firms must continue to abide by their obligations under UK law, including those derived from EU law and continue with implementation plans for legislation that is still to come into effect. The longer term impacts of the referendum decision to leave the EU on the overall regulatory framework for the UK will depend, in part, on the relationship that the UK seeks with the EU in the future.
As a next step, the FCA will be writing to all the users and operators who participated in our thematic sample. The regulator will remind users to be clear about understanding the operational detail of the pools they are active in, meeting best execution obligations as applicable, and other issues the FCA raises in this report. For operators, the FCA will be providing more detailed individual feedback on our findings and requesting those firms to take action where required. Under business-as-usual supervision, the financial watchdog will continue to monitor users, operators and market activity as it relates to dark pools and other sub-markets. As part of its continuing supervisory work, the FCA is also actively monitoring the arrangements that investment managers have in place to ensure best execution and the changes that they have put in place following our 2014 Thematic Review of Best Execution.
The FCA statement and a link to the full report are available here.