The term dark pool – used to describe trading venues that provide alternatives to ‘lit’ national exchanges such as Nasdaq and the NYSE – suggests something shadowy and menacing. And yet in the US alone there are more than 40 SEC-approved alternative trading systems (the formal name for dark pools), and industry observers predict that a significant share of off-exchange trading occurs in these venues.
Critics have suggested that dark pools lack the transparency of the traditional lit venues because they are subject to less regulatory scrutiny, although the SEC voted in July 2018 to require these venues to enhance their reporting to enable greater transparency around conflicts of interest.
Nathaniel Lalone, partner at law firm Katten Muchin Rosenman UK and a legal expert on securities, tells IR Magazine: ‘I think dark pools get outsized attention due to some perceived negative association with the word dark. They serve as a necessary and valuable part of the overall market structure: they are simply a tool that, if used responsibly, can serve a useful purpose.’
That said, with the number of dark-pool trading venues around the world increasing, it is getting harder for IR teams to understand where their stock is traded, who is trading it – and why.
IROs and dark pools
Gary Davies, former CEO of the UK’s IR Society, warns that the situation is a big challenge for IROs. ‘It is harder to know what is being traded in a company’s shares,’ he explains. ‘Traditional market trading that is visible to corporate brokers can be only 25 percent to 30 percent of trade, with much of the rest taking place in dark pools. Combined with a greater proportion of low-touch trading, dark pools make it harder to know what is happening to the shares on a daily basis.’
Todd Kenney, chief technology officer at trading platform company Sterling Trading Tech, agrees. ‘The sheer number of execution venues and the related fragmentation of liquidity in the market is certainly making it more difficult for investor relations teams to understand where and how their stock is being traded,’ he observes. ‘When you add in dark pools, it has become a challenge to get a strong understanding of the dynamics behind your listing.’
Davies adds that the fragmented nature of the market is another example of the increased complexity public companies and IR teams face. ‘It makes it harder to understand an intra-day share price move because the type, shape and size of trades are no longer visible,’ he says. ‘While this might not change the medium-term direction of a share price, it’s very helpful to know what short-term influences might be affecting sentiment around a company’s shares in order to enable IR to react if needed.’
Stock control and dark pools
Ricardo Jiménez, head of IR at Spanish multinational Ferrovial, conducted a study to investigate how much of his company’s trading was taking place away from traditional stock exchanges. ‘We realized that more than 50 percent of the real volume was being traded somewhere that we didn’t have any visibility – that is, all these alternative platforms. More and more, we are losing control of who owns our stock,’ he tells IR Magazine.
Did this come as a shock? ‘Not so much a shock as putting a dimension on a trend we had been seeing for some time,’ Jiménez says. ‘We were less and less able to identify who was trading our stock, initially in terms of actual names but as time went by also in terms of real trading volumes – which were much higher than we thought – because much of the volume was taking place in multilateral trading facilities and through dark trading. Transparency is no longer available.’
Naturally, this posed huge challenges from an IR perspective. ‘It meant less accurate responses internally to the question of who was trading our stock and where the relevant buyers and sellers were,’ says Jiménez. ‘We in turn started to get this information either directly from the investors themselves or through the shareholder identification exercises that are conducted before our board meetings each quarter.’
Given his experience, what advice would Jiménez give to IR professionals? ‘IR teams need to understand the complexities of market structures, the platforms in place, the market players and their relevance,’ he says. ‘Regulation is changing in the marketplace – especially following Mifid II – and it will continue to change as there are several regulatory reviews in the making.
‘Companies need to be aware of how this impacts their relationship with current shareholders, with potential investors and financial institutions that trade in their stock, as it will also impact the way they communicate with all their stakeholders.’
To develop a better understanding of this, contact with those trading in the market venues is key, notes Jiménez: ‘Brokers and financial institutions deal with the changing market structure on a daily basis and can provide very useful insights as to what is happening in the marketplace.’
IR and market structure
This raises a question around the extent to which IR teams need to be market structure experts – and, if so, how they can develop a better understanding.
‘In terms of trading in the shares, in essence an IR professional should try to understand where shares are traded, how much is on public exchanges, how much is in dark pools and obviously who owns your shares, but also what the short position is and who is lending stock out,’ Davies suggests.
Kenney adds that IR teams also need to understand that market structures are constantly evolving. ‘Talking to a diverse mix of market participants is the best method to get this information,’ he suggests. ‘The needs of a buy-side trader who desires to buy or sell a large block of stock with minimal market impact, for example, are far different from a smaller investor when selecting an execution strategy.’
He therefore recommends that IROs ‘talk to the buy side, the sell side, market-makers and exchanges to get a feel for how each of these selects and interacts with market centers.’
Tim Quast, founder and president of IR market analytics firm ModernIR, takes this further. ‘It’s harder for traditional sources of IR market intelligence to provide meaningful insight,’ he asserts. ‘The specialists on the NYSE floor had great access to information. Today’s designated market-makers don’t have that, because they’re interacting with flow rather than seeing both sides of the buy-and-sell ledger the way the old specialists did.’
Quast therefore says that ‘there’s an absolute baseline requirement for anybody in the investor relations profession to have a rudimentary grasp of how the stock market works today. The equity market is an interconnected data network that functions like a grocery store. There are products called equities on the shelves and there are consumers – the great majority of them now machines – coming and going with different reasons for buying and selling. That changes the job from one principally focused on telling the story to investors to a much more data-driven, measurementfocused strategic role.’
This in itself has huge implications for the work of IROs, who should, Quast says, understand the core tenets of the SEC’s Regulation National Market System, how prices are set, how orders move around the market and the difference between marketable and non-marketable trades. ‘It’s the beginning point for overseeing the equity capital market, and the IRO is the chief intelligence officer for equity markets,’ he adds.
The onward march of dark pools
There appears to be no stopping the march of dark pools: Quast cites statistics from ModernIR indicating that the NYSE currently handles 24 percent of US trading volume, Nasdaq about 20 percent, the Chicago Board Options Exchange about 17 percent, IEX about 3 percent – and dark pools 36 percent.
‘Dark pools have become the largest part of market volume because the displayed stock markets are inefficient places for investors to find stable price and size for orders,’ Quast says. ‘The inherent flaw of the market is how it forces all stocks to trade the same way when all stocks are not equal.’
Kenney agrees. ‘I believe they are an evolution of the market, primarily born out of both necessity and the needs of the various market participants as well as the opportunity for institutions to use them for internalization,’ he says.
But Davies pushes back on dark pools from the perspective that, at their heart, they create a problem that is not beneficial to an effective listed company. ‘Companies when listed have a duty of transparency: dark pools mean there is no reciprocal transparency in trading in the shares on a daily basis,’ he explains.
Quast contends, however, that the problem isn’t dark pools per se. ‘There is nothing inherently dangerous about dark pools,’ he says. ‘Rather, they are a manifestation of a structural problem with the stock market that diminishes the capacity of real investment behavior to meet efficiently in it.’
SIDEBAR: Dark pools and Mifid II
There has been much discussion about the possible impact of Mifid II on dark pools, given that the regulation tries to increase transparency and incentivize activity toward public exchanges.
But Mifid II’s impact is as yet unclear: if such an impact even exists, it is not what was intended. ‘I’m not sure the data collected permits a particular conclusion to be drawn,’ says Nathaniel Lalone, partner at law firm Katten Muchin Rosenman UK, regarding the influence of Mifid II on dark pools. ‘Of course, Mifid II includes certain features – in particular the so-called double-volume cap – designed to disfavor the use of dark pools and bring more trading onto lit venues.’
Todd Kenney, chief technology officer at trading platform company Sterling Trading Tech, agrees. ‘The impact of Mifid II on dark pools is less than expected – that’s my take on it,’ he observes. ‘The volume-cap limitations, though well intended, can quite easily be managed by operators. The resurgence of dark-pool market volume points to this exactly.’
Lalone adds: ‘Some data suggests that, while the use of dark pools has in fact diminished due to the doublevolume caps, the trading has not in fact migrated to lit venues but has gone to the fully over-the-counter – or off-venue – market. This is clearly not what the policymakers had intended.’
This article was published in the Winter 2019 issue of IR Magazine.