Published On: Sat, Aug 10th, 2013

What Does Best Execution Mean in a Dark Pool?

Purpose:
Alternative venues are steadily rising in prominence in Asia with the help of technology, regulation and user education. As sophistication of Asia buy-sides continues to improve best execution rules will require granular and more transparent definitions in markets that are just now coming to grips with multi-venue market structure.

In order to get a sense of what Asia’s electronic trading industry considered best execution for non-display venues we asked ‘What does best execution mean in a dark pool?’

Results:
What does best execution mean in a dark pool?

What does best execution mean in a dark pool?

Analysis:
Licensed representatives of financial firms have a fiduciary responsibility to act in the best interest of the client, as any prudent person would act on behalf of themselves. Dark pools or off-exchange trading has been around since the advent of barter where a bilateral trade is conducted anonymously and at an agreed upon price. Modern technology and financial regulations have accelerated the proliferation of dark pools and driven a desire for more granular definition and expectation around best execution in these types of venues.

From the results of our opinion poll it is clear that there are mixed expectations of what encompasses best execution in off-exchange trading. The most important item appears to be ‘No information leakage between desks (17.24%)’. Anonymity is the key here. You do not want word going round that a big order to buy XYZ is going to hit the market. Scalpers will bid up the price ahead of you and sell it back at a higher price.

This next issue up, was understanding why a broker sends an order to a pool (13.79%). A broker may try to cross orders internally to provide liquidity to its other desks or meet other commission requirements, reasons that do not necessarily have the client at heart.

No one likes to be gamed in a dark pool. Not only will it hurt the reputation of the venue and see its large, liquid long-only clients trade elsewhere, it will undermine participant use and be negatively viewed by the retail community. Using sophisticated anti-gaming logic (10.34%) was on the list of the buy-side requirements for best execution in dark pools.

Based on experience, some buy-side firms are cautious about using particular dark pools. Rival algo-driven buy-side players may be trying to gauge how much size they could potentially be putting into the market then get ahead of that order. That is why knowing where your broker will send your order (6.9%) came up on the list of best execution in a dark pool.

Caution is king. That is why ‘all of the above’ (51.72%) was the clear cut majority response for the industry. If you are planning to offer access to a dark pool or launch a venue it may help to ensure all four points mentioned above are covered and truly offer best execution.

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