By Antoine Juaristi, Lovells
The recent financial crisis has brought to light the complexity of certain financial products, as well as a profound lack of transparency within the financial system. Despite strong criticism denouncing this lack of transparency, investors have, nevertheless, increasingly had recourse to hidden trading platforms on the equity market, better known as dark pools.
By way of clarification, let us dive into the world of dark pools! The EU Markets in Financial Instruments Directive, MIFID, came into force two years ago. It allowed for the opening up of new trading systems, particularly in the equities market.
In order to ensure market transparency and integrity, this Directive set up pre-trade and post-trade transparency requirements. For example, the directive’s pre-trade transparency requirements include the obligation to make public on a continuous basis current bid and offer prices and the depth of trading interests at these prices during a continuous basis during trading hours.
This EU directive also allows for the waiver of these obligations for transactions that are large in scale compared to normal market size. The aim is to prevent the acquisition or transfer of a large number of shares from triggering a large increase or decrease in share prices if this order were made public. This has spurred the development of dark pools for block trades.
Dark Pools thus refers to trading systems operating without pre-trade transparency using the waivers provided for in the MIFID. They currently represent less than 10% of trade volume on the European equity shares market.
The most well-known dark pools include: Smart Pool founded by NYSE Euronext, Baïkal founded by the London stock exchange (which recently merged with the alternative European platform Turquoise, founded by BNP Paribas, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, Merrill Lynch, Morgan Stanley, Société Générale and UBS) or Neuro Dark founded by Nasdaq OMX.
Although post-trade transparency requirements apply to dark pools (in particular the obligation to make public the price, volume and time of transactions), they are criticized for their lack of pre-trade transparency. Some investors could sell large quantities of shares within a regulated market after purchasing these same shares at a much lower price from a dark pool.
Beyond the risk of price manipulation, the rise of dark pools might also distort competition and create a disadvantage for private investors who do not trade in large quantities of shares and who cannot have recourse to dark pools. This highlights the risk of liquidity fragmentation and, as a consequence, a possible deterioration of the price formation process on the equities market.
Due to the multiplication of shares trading systems, equity issuers complain when the price of their shares is altered. Since they don’t know the exact stock exchange price of their shares, they can’t determine the actual price of their financial capitalization.
In the US, dark pools emerged in the 1990s. In October 2009, because of the growing number of those hidden platforms, the Stock Exchange Commission proposed measures intended to increase transparency of dark pools in the United States, so investors get a clearer view of stock prices and liquidity.
Did MIFID really achieve its aim of protecting investors through setting up a more integrated, transparent, effective and competitive capital market? The European Commission has scheduled a revision of MIFID for 2010, which we hope will provide an opportunity for the pre-negotiation transparency waivers to be rethought in order to prevent the development of this dark side of the financial markets.
Antoine Juaristi is Partner at Lovells, in the Dispute Resolution Group. Lovells is one of the largest international law firms with offices in Europe, Asia and the United States.
