Shining a light on Dark Pools

The London Stock Exchange dominance in share trading has been eroding at a rapid rate. Then an obscure piece of research handed it a gift. James Moore reports on the exchanges' battle
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The Independent Online

Xavier Rolet knew he had a fight on his hands when he took on the job of running the London Stock Exchange.

Yesterday showed just how tough the going has been getting. Europe's "Mifid" directive has seen the exchange's dominance in equity trading – at least when it comes to the FTSE 100 – eaten away by a string of rivals. So why was it that Mr Rolet had a Cheshire Cat grin on his face?

Even though profits were ahead of City expectations, a fall of nearly a fifth after stripping out one-offs (they came in at £280m for the year ending 31 March) does not make cheerful reading. Mr Rolet, however, was handed a gift by rivals on Thursday.

It came in the form of a piece of research by Themis Trading which suggested that rival "dark" trading pools – beloved of big institutions needing to buy and sell large tranches of shares in private – weren't as dark as they appeared to be. Themis suggested that if you were clever enough you might be able to find out who was doing what in the dark pools operated by some of the LSE's rivals.

Suddenly, from having the sixth biggest player (in terms of trading volumes) when the LSE took control of the Turquoise dark pool in February, the LSE had the number one, if only over the last couple of days.

Chi-X, the LSE's biggest competitor, acted with remarkable speed to correct the problem, and argued that clients were, anyway, aware of the situation from the start. Its chief executive, Alasdair Haynes said: " The Themis report is interesting and in response to market participant reaction we immediately changed the data so that even the very, very limited post trade data from the dark book has been stopped. This is now sorted and all our clients are aware of this immediate change."

Mr Haynes said yesterday: "It's fine for them to say they are number one. As far as I'm concerned, that's not what it's all about. We have an open and free market and the important thing for us it that we are building the right marketplace, the best possible marketplace for the future."

It's worth pointing out that Chi-X (and its rivals) also operates a more traditional "lit" trading pool, where dealers can see the orders that are placed and received.

Still Mr Rolet is alive to the main chance, and will not be shy about ramming home the Themis point. The competition for trading in the biggest, and most liquid stocks in Europe is brutal. Turquoise, for example, was loss-making when the LSE bought it and is still loss-making today. So are many rivals. That is not sustainable long term, and Mr Rolet and his team will use every string in their bows to ensure that their trading platform remains a survivor when the dust settles.

"They will undoubtedly get backsome of what they have lost," says Mr Rolet. "But we are hopeful that we can retain at least some of the new business. We respect Chi-X and BATs and the others, they are good businesses. But the fact that they have had to re-tool, it points to a deeper question about governance and the neutrality of your platform. What we bring to the table is that we are neutral, that is the true value of our offering."

Another point of contention is how much access the much-discussed "black boxes" are allowed to have to dark pools. Mr Rolet says his is aimed squarely at big institutions. Mr Haynes argues that his is open to all comers, and this is a virtue. Which is right?

Black boxes have long been controversial. Many still believe these algorithm-driven systems were the cause of the astonishing events in the US on our election day, when the Dow went into freefall. European markets have been electronically driven for far longer than the US. In fact, the boxes are needed to allow markets like the LSE and Chi-X to operate alongside and compete with each other. The boxes, trading across them all, ensure that major price differences between the different markets are ironed out. There are also circuit breakers in place to prevent them from getting into a vicious circle of selling at times of extreme volatility and, if the worst comes to the worst, the LSE can, for example declare a "fast market", as it did after the July 7 terror attacks on London. In this situation, the boxes are turned off. But all the same, that doesn't stop people being discomfited by the thought that the things produce odd effects and could run amok. The debate between the LSE and Chi-X is what impact they have on dark pools and the virtue of the latter as a means for pension funds to buy and sell large tranches of shares. As to who is right, only time will tell.

In the meantime, the LSE's market share has stabilised at around 62 per cent, for now. But the battle between traditional exchanges and their newer rivals is getting hotter.

Dark Pools: Why they have become a key part of the markets

It might sound like something something cooked up by George Lucas or James Cameron for their latest sci-fi epic, but dark pools are neither as complex nor as frightening as they sound. A "dark" pool of liquidity is a trading venue, aimed at institutional investors wanting to buy or sell large blocks of shares.

In recent years, the proliferation of computerised "black box" trading systems used by investment banks and other big institutions have made for far more active trading. Markets are now significantly faster, and the average trade size has dropped markedly – from about £40,000 a decade or so ago to as little as £4,000 today. The speed and efficiency of exchanges has also increased. However, that creates a problem for big institutions such as pension funds, which often have very substantial holdings and have the need to buy and sell large blocks of shares.

Let's say shares in AB Bank hit 200p and the fund manager thinks it is the right time to cash in on pension fund D's stake. The problem facing him is that if he tries to sell all at once, the market will see him coming, because the stock exchange's "order book" will register a huge sell order that will be seen on dealing screens around the City. The price of the shares will immediately fall as a result. The seller will stand almost no chance of getting 200p. They could sell lots of small tranches of shares, but that can take a long time, and can prove extremely expensive in terms of dealing and settlement fees.

However, in a dark pool, the seller can put in a big tranche of shares without anyone knowing they are there. They will sit in the pool until they are matched by a big "buy" order at the same price. Because the trade does not appear on stock-exchange screens until it is complete, there is no chance of the market moving against either buyer or seller.