Evolution of Dark Pools

Dark Pool Routing

Introduction

It is fast becoming accepted wisdom that systemic change has occurred in the Capital Markets. We hear increasingly strident voices telling us that markets are too fragmented; best execution is elusive and investors are being disadvantaged. One of the results of this popular criticism is that regulators, who were already under immense pressure to be seen to be tough on their industry, have been encouraged to enforce new rules to limit flash orders, high-frequency trading, dark pools, and other market activities seen as symptoms of the changing markets.

In the EU, the initial impetus for Capital Markets change was MiFID; however, MiFID was itself made in response to major industry shifts which were already occurring before 2007. The European markets, following the lead of the North American markets, were already experiencing an increase in trading volumes, a reduction in bargain sizes, an increase in algorithmic trading and the exponential growth of ‘technical’ trading of Cash market1 instruments. These changes were not the result of the regulatory change – they merely contributed to it.

The pressure for regulatory change comes primarily from institutions such as traditional centralised exchanges which have seen their profitability eroded by the new market structures. That does not, of course, mean that the criticism of the capital markets should be dismissed out of hand; it suggests that what we need is a careful assessment of the functioning of capital markets, taking into account both the changes in behaviour which have fed the growth in multiple execution venues and the technological responses which have been developed to deal with the new challenges of execution.

This paper makes the case for adaptive smart order routing as a tool for managing best execution in a dark pool landscape and describes the mechanisms that firms will need to successfully manage their order flow through such venues.