Firms that operate dark pools have made progress in addressing the promotion and management of conflicts of interest, but some users of the trading venues need to improve their own due diligence processes, said the U.K.’s financial watchdog.
Dark pools are trading venues in which the price and volume of all orders are hidden and anonymous.
Users of dark pools — including money managers, hedge funds and insurers — welcome the additional liquidity, lower risk of information leakage and beneficial impact potential on pricing and costs that come with dark pools, said the Financial Conduct Authority in a report published Thursday about U.K. equity market dark pools.
However, there are areas for improvement from both the operator and user communities. In order to work toward best practice, users should be “very clear about the rationale for using dark pools,” and should “conduct adequate due diligence to thoroughly understand the operating model of a pool before commencing trading activity,” the report said. Users should also be able to monitor ongoing activity and the outcomes that are directly attributable to their use of a dark pool, the report added.
“The level of due diligence undertaken by users before joining or agreeing to participate in a dark pool was not consistently thorough. We noted, for example, that some users had not fully understood operational details for some of the pools before commencing trading,” the report said. Users were also not always aware of whether pre-agreed trading preferences were maintained when their trades were routed onward to third-party pool operators.
“Where due diligence by users is insufficiently thorough or the operation of a dark pool is not fully understood, it may bring into question the user’s compliance where they owe best execution obligations to an underlying client,” the FCA warned.
Operator recommendations included providing clear detail about the design and operation of a dark pool; improving the monitoring of activity in pools, focusing on operational integrity, best execution, client preferences and unwanted trading activity; and strengthening policies and procedures for oversight and escalation as one way of doing more to identify and manage conflicts of interest.
“Advances in technology have had a huge impact on equity markets which, in turn, give rise to new forms of conduct risk,” said Andrew Bailey, CEO at the FCA, in a statement accompanying the report. “Similar changes are underway across other products and markets so it is important for boards and senior management to read across, and apply what they have already learned, to rapid changes occurring elsewhere.”