Jeffrey O’Connor is a senior execution consultant and market insight analyst for US equities at Liquidnet
The recent surge in retail trading is important for the vibrancy of capital markets and the price formation process. However, the market structure which underpins elements of equity trading has also come under severe criticism by these new entrants.
This increased attention has given rise to theories about parts of financial markets which play a critical role in their efficient functioning, but which can be poorly understood.
Every day, trillions of dollars of equities change hands across global capital markets. These trades come in different shapes and sizes – retail investors may buy or sell a few hundred or thousand dollars of a particular stock, whereas institutional investors can sometimes buy shares worth millions or even hundreds of millions of dollars at a time, typically defined as blocks (10,000 shares or greater).
Trading large blocks in the same marketplaces that serve retail investors is difficult due to the average size of the transactions on exchanges. To do this would require institutions to potentially split the order into hundreds of slices, and risk creating a sharp movement in the share price due to information leakage.
To avoid significant market impact, for decades, institutions have used anonymous pools of liquidity where they can buy and sell large blocks of stock without causing market impact. A recent Securities and Exchange Commission investigation into information leakage between brokers and hedge funds was not focused on institutional dark pool execution, but rather the formation of large blocks via “high touch” trading desks.
As it pertains to dark pool transactions, the structure is one of anonymity and non-communication between broker and contra-parties involved. However, the spotlight on the issue has raised chatter in online forums regarding the state of equity market structure and questions over the fairness of block trading.
Institutions have a fiduciary duty to execute their clients’ trades at the best possible price. This requires them to choose the best possible venue for their block while preventing information leakage which could give other participants an unfair trading advantage at their detriment. For institutions, this means understanding that just because something is being executed in the dark doesn’t necessarily mean that it is the best venue of choice. This is where the picture gets more complex.
Getting ahead of reform
The SEC’s current investigation into block trading could be at the heart of future reforms. It is important to note that this investigation is not tackling the principle of block trading, rather a particular trading model that resulted in the transfer of information which violated market rules. It seems likely that any new transparency rules will focus on communication between parties involved in trading large blocks to ensure that privileged information on a particular order is not leaked.
In the absence of stricter regulations, it is the responsibility of the brokers and investors to uphold the integrity of block trading as a vital function in capital markets. Brokers engaged in block trading must be sure to review their processes in order to protect market-sensitive data at all costs, as well as ensuring strict controls of their client communications.
Investors may use brokers for many reasons – from access to research to execution – but when it comes to block trades, it makes sense to include a venue(s) which has an unconflicted model to ensure they are using the most appropriate one(s) in their search for block liquidity for a particular order.
There are deep-rooted and fundamental misunderstandings around block trading and dark pools that need to be addressed. Dark pools are a vital mechanism for supporting the functioning of modern markets – protecting the integrity of the price formation process on lit markets, while helping institutions execute very large trades.
These models have coexisted for many years. With greater participation in financial markets from a larger group of investors, they need to be better understood.