United States: The FCA Peers Into Dark Pools

On July 21, 2016, the Financial Conduct Authority (FCA) of the United Kingdom (UK) published a thematic review:  UK equity market dark pools - Role, promotion and oversight in wholesale markets (TR 16/5) (Review): http://www.fca.org.uk/your-fca/documents/thematic-reviews/tr16-05.

Background

The FCA uses thematic reviews to assess a current or emerging risk relating to an issue or product across a number of firms within a sector or market. The Review examined (a) the promotion undertaken by dark pool operators, where the FCA sought to assess actual delivery versus promises and/or promotional materials proffered; and (b) the quality of the identification, management and disclosure of conflicts of interest by pool operators. In the Review, a 'dark pool' is defined as a trading venue with no pre-trade transparency in that all orders are hidden as to price and volume and are anonymous. This might include a broker crossing network (BCN), for example.

The findings and key messages in the Review were specifically identified as being pertinent to asset managers, who commonly use dark pools. Indeed, in developing its findings, it appears that the FCA met with a number of asset managers, as well as dark pool operators and aggregators, to understand better the relevant dynamics across the market and the responsibilities on each side of a trade.

A summary of the key findings of the Review are set out below.

Key findings

Asset managers

  • Asset managers should be clear about their rationale for using or not using dark pools (why, how and when). It is very important that asset managers 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.

Asset managers and dark pool operators

  • Asset managers 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.

  • Asset managers and operators should carefully consider the new MiFID II rules (that will apply from January 3, 2018) and the impact on existing and planned business models. Much financial regulation currently applicable in the UK derives from European Union (EU) legislation. This regulation will remain applicable until any changes are made, which will be a matter for the Government and Parliament of the UK. 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.

Dark pool operators

  • 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.

Good and bad practices by operators of dark pools

The FCA also published a list of findings of what the FCA perceives to be good and bad practices by dark pool operators which is of use to asset managers in due diligence processes and in monitoring ongoing activity and outcomes. Some of the findings are listed below.

Good practices

  • Detailed and focused due diligence on proposed activity in the pool by prospective clients.

  • Onboarding discussions focused on clients' trading style, strategies, activity volumes and goals.

  • Central storage for client preferences used as a 'golden source' for such data.

  • Dynamic reassessment of routing logic based on market activity (e.g., price volatility, liquidity).

  • Monitoring the latency of price feeds performed on a real-time basis.

  • A clear process with defined thresholds for identifying and acting on stale prices.

  • Analysing and grouping clients according to set criteria based on trading activity. Daily systematic checking of client preferences through a proactive push system.

  • Establishing clearly defined metrics to monitor activity by group.

  • Clear governance structures and appropriate terms of reference for each committee.

  • Tight control over access to the dark pool platform data, with individuals logged on a 'need to know' list that was tightly regulated and frequently refreshed.

  • Regular updates to the conflicts of interest policy and the register and recording of specific conflicts of interest that can arise with respect to its dark pool.

  • Inclusion of specific scenarios related to algorithmic trading and the BCN in a conflicts of interest matrix.

  • Tailored conflicts of interest training to include risks relating specifically to dark pools.

  • Overarching infrastructure that specifically addressed dark pools, including best execution.

  • Evidence of issues being identified and raised at the governance committee responsible for overseeing the pool by the business or by second or third lines of defence.

  • A fully coordinated approach to control by the chief operating officer, compliance and technical support units.

Bad practices

  • Generic due diligence that did not appropriately identify the risks posed by a client on an electronic trading platform.

  • Stale assessments of client classifications and risk profiles with refresh not scheduled.

  • Collection of preference information from clients in an inconsistent and uncontrolled manner.

  • Slow adjustment (or removal) of a speed bump originally introduced to equalise access to a pool after the need for it was resolved via other technical improvements.

  • Allowing access by an in-house trading desk to its BCN via different infrastructure than clients, which gave it a potential latency advantage constrained only by management controls.

  • Monitoring of pricing feeds on a post-trade basis only.

  • No evidence of systematic monitoring of the client's activity in the pool.

  • Use of pricing based on stale data (more than one second old), which then affected the smart order router.

  • Lack of breach tracking or follow-up against breaches of undesirable activity thresholds.

  • Use of outdated 'need to know' employee lists enabling staff who had left the relevant area of the firm continued access to dark pool information.

  • System design that potentially allowed some traders to see resting orders and the aggregated order book.

  • Allowing potentially hundreds of staff across the support infrastructure (i.e., a number well above any of its peer group of a similar scale) to have access to live trade data.

  • Use of very generic high-level policies that were non-specific and difficult to apply to dark pools.

  • Weak articulation of risks and conflicts of interest through the whole trading cycle.

  • Ineffective internal management reports that relied on incorrect or outdated data.

  • Weak escalation process for matters related to oversight with no evidence that the process was ever utilised.

  • Inadequate definition and separation of responsibility between the first and second lines of defence for monitoring best execution or conflicts of interest related to dark pools.

Next steps

Next steps for asset managers that are dark pool users are:

  • the FCA expects that asset managers that are dark pool users carefully will review the contents of the Review and its key messages, and reflect on their own operations and practices;

  • ensure that business practices are fit for purpose and that these are supported by appropriate second line of defence controls. Users should ensure that they understand the attributes of individual pools and monitor their use to ensure that the expected benefits are obtained; and

  • assess the risks and issues identified in the Review. Some additional obligations in MiFID II are intended to address a number of concerns specific to dark pools. Firms need to improve their current systems and controls and be ready for the implementation of future policy changes (including those associated with Brexit).

The FCA Peers Into Dark Pools

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.