Should European Dark Pools Offer Better Prices?

Today, NYFIX Euro Millennium MTF platform will temporarily amend its algorithm to offer matching at the midpoint of the reference market price. The move raises questions about whether European dark pools can offer better prices than lit markets.The neutral Pan-European multilateral trading facility(MTF)has been working with the UK's Financial Service Authority on issues surrounding its interpretation of the pre-trade transparency waiver under MiFID Article 18.1, according to a notice posted on its Web site.

The Pan-European dark pool for cash equities first announced its plan to make the change on March 26 on its Web site. In the market notice, Chris Smith, CEO, NYFIX International, explained: "As participants may be aware, NYFIX has been working closely with the FSA on issues surrounding its interpretation of MiFID Article 18.1 (a), the waiver from pre-trade transparency detailed in MAR 5.7.1 of the FSA Handbook."

Smith went on to explain that NYFIX will be making this temporary change effective April 14, 2009, when Euro Millennium will seek to match participant's orders at mid-point only. But Smith said further "matching reference points" are to be introduced in the coming months. These matching points will include bid and offer and potentially others, including close through the introduction of a matching period occurring after the reference market-closing auction, said Smith in the notice.

The change comes in response to the UK's Financial Services Authority (FSA) examining the new breed of dark liquidity pools to examine the way they work. According to sources on the buy-and sell-sides, the FSA doesn't want the dark liquidity pools to engage in price discovery. "The regulators seem to have an issue with price improvement in the dark," says one sell-side source. "They're saying that should happen in a lit order book," suggested the source. "That's why the FSA has conducted these reviews into the dark books to see which points they cross at and also they're looking at whether there is price formation if they are executing within the spread or other than the midpoint," explained the sell-side source. Previously, with NYFIX Euro Millennium participants could price anywhere in the middle of the spread, which may be considered price improvement by the regulators, noted the sell-side source. "We find that peculiar. We want to get the best possible prices for our clients, you can't trade large blocks of stocks in the lit book," added the sell-side source.

So what does all this mean and why should the buy-side care? I spoke to Smith in early February before Euro Millennium had announced any change to its matching algorithm. At that time, Smith said, "We're seeing acceptance of dark liquidity and dark venues." In January, Euro Millennium gave up 14.4 basis points of price improvement on average across the whole system across all the trades that were done, said Smith. (Also, in January, Euro Millennium had $2.5 billion in executed value on the platform, up from $ 1.5 billion in December of 2009. And it saw a 500 percent increase in the volume from November to December of last year.)

Smith explained that Euro Millennium's pool is very deep and broad and that it has different instruments in the pools, such as small cap and large cap stocks. "That is slightly different than some of the MTFs (i.e., Chi-X) that trade based on the liquid stocks." In terms of what clients expect, he cited "price improvement and limited market impact and that's what dark pools generate," he added.

But now we are hearing that the dark pools should not provide better prices than the exchanges or lit markets. "Dark pools are not there to act as a price discovery mechanism. They are effectively there to be crossing orders," said Anthony Whalley, investment director and head of dealing and derivatives at Scottish Widows Investment Partnership, a money management firm in Edinburgh.

Still, the dark pools are going to be in demand because the levels of volatility in the European markets have increased and average execution sizes on the lit markets are shrinking.

But apparently the FSA is still monitoring the dark pools to understand how they work with respect to the MiFID pre-trade transparency rules. For example, lit MTFs have also introduced dark order types so the FSA wants to make sure that these new dark pools are in compliance with the rules.NYFIX Euro Millennium is changing its algorithm for matching stocks in response to meetings with the UK's FSA. Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio