Wednesday 27 August 2014 3:19 pm

Brussels must see the lighter side of dark pools – or watch City innovation wither

FROM allegedly failing to execute trades at the best price, to clients being misled about the type of trade being executed, trading in dark pools has taken its fair share of criticism recently. But against this flurry of negative headlines, and with the EU seeking to enforce stricter controls on dark pools, it is important to remind ourselves why investors want to trade away from public exchanges, without prices being displayed until after execution.

The most obvious advantage of trading through dark pools is that it lowers the overall cost of trading. It also protects against market impact when trading large block orders – an activity that pension funds need to carry out every day. While recent troubles underscore the need for smarter regulation, EU proposals to cap the proportion of share trading done in dark pools threaten to kill the goose that lays the golden eggs.

The EU’s agenda to enforce stricter controls conflicts with the UK’s creative and innovative attitude towards financial markets. Brussels has appointed itself judge, jury, and executioner for how European markets should function, but without any substantive evidence on the net consequences of new dark trading rules for pension funds and money managers (arguably the most important vehicle through which European end retail investors hold assets).

It also appears that there is something of a regional bias emanating from Brussels. The UK aside, the majority of EU member states don’t operate dark pools. It just so happens that the leading dark pool operators are based in the City. What we have is a regulatory experiment, drawn up by people inevitably divorced from the frontline of trading, and politically motivated to increase transparency in financial services above all else. But transparency is not a panacea. And in this case, it appears that the full consequences of this transparency have not been understood.

The problem is that, by following this agenda, Brussels could end up shooting itself in the foot. When you attack dark pools, you aren’t just hitting the UK, you are making Europe as a whole a less attractive market. If Europe wants a thriving capital market that attracts others to trade and list, then it shouldn’t adopt a one-size-fits-all approach. What is needed is an environment that nurtures innovation and encourages people to devise new styles of trading. Assuming this is accepted, there should be an industry consensus that the benefits of dark trading far outweigh the negatives.

Certainly, there are competition advantages. In equity trading, alternative venues keep traditional exchanges on their toes with regard to fees and performance. Alternative venues also provide investors with a greater choice of where and how to trade. Dark pools, for example, wouldn’t exist without the demand from investors to trade larger volumes of stock, which can prove extremely challenging on a traditional exchange. It is also worth noting that multilateral trading facilities' (MTF) dark venues typically provide greater post-trade transparency and fairness than other dark pools. Therefore, instead of seeing dark trading as something sinister, look at it as the latest form of financial innovation. Call it the financial market’s equivalent of eBay, an e-commerce platform with slightly different rules, that challenges the status quo.

To fix the damage that the EU’s new-found confidence in dirigisme could end up producing, Brussels needs to recognise the important role UK innovation plays in making Europe a key global financial market. Whether it’s dark pools, or the next big idea that improves how markets operate, for Europe to create jobs and drive growth, it will need to incentivise creativity and become more business friendly. In that context, the EU can no longer afford to pursue unnecessary regulatory measures that kill innovation.

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.