Nasdaq Offers Dark Pool Workaround for Trades Forced Into Light

  • Nasdaq seeing growing interest for auction on demand trading
  • Says dark pools going out of business for European stocks

New reporting rules intended to pull equity trading out of dark pools and restore transparency to the market are spawning workarounds.

Nasdaq Inc. is testing a service in Scandinavia, called auction on demand, that faces laxer reporting requirements, according to Henrik Husman, vice president for equity products. The company, which runs most of the major exchanges in the Nordic and Baltic regions as well as a dark pool, is responding to investor demand for new approaches that withhold as much information as possible for as long as possible.

“What we historically have seen is that there has been -- and still is -- an appetite for trading in the dark,” Husman said in an interview. Periodic auction trading models like auction on demand are seeing “growing interest” since “order information does not have to be displayed,” he said.

Investors now do as much as half of their equity trading in dark pools and other venues where bid and sell orders can be concealed. They have proved popular among large institutional investors such as Norway’s $960 billion wealth fund, which trade in large blocks and want to stop other traders from taking advantage of such orders. But from next year, much of that pre-trade data will have to be made public as the new European Union rules come into force.

Read more on Dark-Pool clampdown here

Come January, ”dark pools as we know them today will be out of business for the next six months for most European stocks,” Husman said. “And the crossing networks operated by a lot of investment banks seem to be facing a need to find a new kind of legal environment for that kind of trading to continue.”

European Demand

In auctions on demand a buyer or seller places an order at any time and a transaction only takes place if a matching bid or offer comes in, according to Nasdaq. Then the price and volume are made public. A trade takes a maximum of 100 milliseconds.

Order sizes on the new service are already at least 10 times larger than on the exchange’s so-called lit order book, Husman said. It’s considering expanding to include European shares trading on London’s multilateral trading facilities.

“We have seen a demand for using our trading model not only for Nordic shares, but also for the pan-European stocks as well,” Husman said.

Denmark’s regulator is monitoring the development. The product is allowed under MiFID II and mirrors similar services popping up at other exchanges, said Anders Balling, head of the Copenhagen-based Financial Supervisory Authority’s capital markets division.

“A large participant isn’t the same as a smaller one,” Balling said. “Within the limits of MiFID II, product innovation from exchanges is a good thing. Our study of transparency in the mortgage bond market shows there are pros and cons to full transparency.”

Exceeding the Cap

(Denmark’s $440 billion covered bond market, the world’s biggest backed by mortgages, has been grappling with similar waivers for bond trading.)

Market participants had been expecting a reprieve of sorts from full disclosure since MiFID II allows for dispensations, to avoid excessive price moves that large orders can trigger. But regulators intend now to cap the use of two of four waivers amid concerns that trade on lit venues will be too little to ensure pricing is set correctly.

Come January, no more than 8 percent of all trading in a liquid stock, across all venues, can be carried out under two of the dispensations, and that 8 percent is based on the previous 12 months’ trade. That cap will be exceeded this year, Husman said.

“Based on the last 12 months of trading in Nordic stocks, it seems all of our liquid stocks will be impacted by the volume cap,” he said. “Which means that one fine day in January ESMA will kindly ask the market participants to shut down the dark pool trading as well as negotiated trades.”

The caps last for six months. That will force more trade onto lit venues, so theoretically the volume done in dark pools could fall below the 8 percent, allowing use of the dispensations. Husman said he’s not expecting this. Market participants are likely to pursue other means to avoid disclosure, including auctions on demand.

“This is clearly a more transparent and secure way to trade then the current set-up, though in the optimal world all interests would participate in the lit transformation process,” he said. “We don’t set the rules and so we are just trying to make sure that we have a competitive offering.”

— With assistance by Silla Brush, and Will Hadfield

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