Stock exchanges around the globe are engaged in various high-noon equities shootouts, and the sophisticated trading venues called dark pools are in the line of fire.

Developing an anonymous block trading facility was only one of the JSE’s initiatives to attract trade and increase liquidity to South African capital markets, way back in 2010.

Like most other offshore exchanges, the JSE sought to stem the loss of trading income from its public order books to dark pools, mostly run by private banks and brokers. Some of the world’s bigger players in this space include JPMorgan Chase, Barclays Capital and Credit Suisse.

Dark pools primarily exist to facilitate off-exchange block trading by institutional investors who do not wish to affect the markets with their large orders and obtain adverse prices for their trades.

Consider a run-of-the-mill share buy-back where a company has to repurchase all of its own stock from minority stakeholders to be able to delist.

Such a corporate action could have a sudden and adverse influence on market value, expenses and potentially debt levels, as some investors could trade on the news in an instant.

Concluding the deal in the “dark” initially, involved parties can keep things on the down-low and hopefully avoid spiralling share prices.

The biggest advantage of dark pools, according to Investopedia, is that market impact is significantly reduced for large orders and transaction costs are lower, since dark pool trades do not have to pay exchange fees.

Stock exchanges are more regulated and therefore have higher costs to investors. In effect, the exchanges are losing business.

The NYSE recently offered to cut fees to better compete with these alternative trading systems.

The JSE does not offer dark pools, but it does offer some hidden order functionality with its Dark Functionality Suite. This is a series of products that enable trading strategies by providing a safe haven to execute large orders in a non-visible yet regulated environment, says Valdene Reddy, acting director of capital markets at the JSE.

In November this year, the JSE upgraded its dark pool solution by introducing Iceberg Orders, a functionality that enables the submission of complete orders and only displays a small portion of the total.

“It allows for a trader’s order to reside on the central order book without disclosing his/her full order size,” says Reddy.

Global exchange-owned dark pool providers include NYSE Euronext, BATS Trading and the International Securities Exchange

Since the inception of this off-exchange trading in 1980 in the US, the practice has grown exponentially. Daily volumes of traded financial securities via dark pools now represent a substantial portion of total trading activity worldwide.

Earlier this year, The Wall Street Journal reported that dark pools in Europe had reached a record since the Markets in Financial Instruments Directive (MiFID II) went live at the start of last year despite the European Union regulation aiming to shift volumes onto traditional (lit) exchanges.

Ironically, the practice has been riding on the Regulation National Market System (NMS) in the USA and MiFID in the EU. It has been driven by the slicing of orders on exchanges’ public order books into ever-smaller sizes by algorithmic trading and increasing activity on alternative trading platforms, which the regulatory frameworks enabled to increase liquidity flows.

The share of US stock trades executed on dark pools and other off-market vehicles is up by almost 40% this year, the WSJ reveals.

Similar stats for the local scenario aren’t readily available.

Regulators everywhere seem very concerned about this rise in popularity of dark pools. In June, both the SEC and the European Commission announced reviews of the impact of off-exchange equity trading platforms with respect to market access, price transparency, and liquidity deepening or price fragmentation.

Rules to limit dark pool trading have already been put in place in Canada and Australia.

The same goes for South Africa’s Financial Markets Review. National Treasury says there will be an updated version released before the end of the year.

Although under intense scrutiny aimed at reform, the use of dark pools for the facilitation of trade remains a viable part of the financial industry, says Alasdair Haynes, founder and CEO of Aquis Exchange.

“When the UK detaches itself from the constrictions of this framework following Brexit considerations, the rules are less clear.”

There has been a dispute between the European Securities and Markets Authority and the UK over the scope of their respective share trading obligations once the UK leaves the European Union.

The UK is a tad more pro-dark pools than the EU regulators are, he says. “However, the EU has a viable alternative in what is called an auction on demand.”

In the auction on-demand order-book, a seller or buyer may place an order at any time, entering it into a periodic auction. When a matching bid or offer comes in, an auction uncross is triggered, and price and volume are made public. Nasdaq Launched its auction on-demand in the Nordics less than two years ago.

It’s possible the prospect of more regulation will steer the pools back to their original mission: liquidity and transparency, Haynes adds.

Until then, the debate rages on. Proponents of traditional exchanges say the secrecy surrounding dark pools leaves the door open to abuses, as there’s no way to know if some clients are getting favoured treatment or if brokers are putting their own interests first.

Defenders of dark pools have argued that their venues are in general safer from that kind of front-running (buying stocks before a big order comes in) and that all investors benefit from competition that has driven down trading costs.

Meanwhile, Mifid II’s double volume caps (DVCs, which were introduced in 2018) are still in play.

DVCs ban dark trading when a transaction accounts for 4% of the total activity on a single dark venue, or 8% of total trading on a wider market basis.

South African regulators do not enforce any trading caps on dark pool activity. For now, at least. BM