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Shining Light on new Dark Pool Regulations

Published in Automated Trader Magazine Issue 40 Q3 2016

Dark pools used to be places for large block trades where institutions could transact significant deals away from prying eyes in order to prevent information leakage. However, the average trade size has come down to rival that of lit venues and regulations are adapting to the fact that dark pools are starting to look like just another exchange.

Dark pools are private forums essentially used for the trading of cash equities. They have existed since at least 1980 and were originally intended to allow institutional investors to execute large trades with reduced market impact. Over time, as pictured overleaf, the average trade size in dark pools has shrunk drastically, meaning that they now compete directly with traditional exchanges. Some authors estimate that off-exchange trading now accounts for as much as 40-50% of total cash equity trading volume, with around 9-12% trading in dark pools. The increased proportion of equity trading occurring away from traditional exchanges combined with political pressure on regulators to more closely regulate OTC markets following the global financial crisis of 2007-2008 means that dark pools have come under increasing scrutiny.


Gabriel Jaccard, MLaw (University of Zurich) is passionate about the legal challenges brought by new technologies and in particular those surrounding FinTech. He is the founder of the community UpLaw (, which aims to share legal works in open access format amongst legal professionals.


From a regulatory point of view, dark pools are not expressly defined by existing law. As a consequence, without any consensus on a precise definition eitaher from a legal or from an economic point of view, the qualification of a trading venue as a 'dark pool' is often vague. aFurthermore, the qualification of a venue as a dark pool may depend upon the specificities of the respective national 'Market Infrastructure' regime.

There are several reasons to improve the regulation of dark pools. Firstly, even though dark pools did not cause the financial crisis, voters are keen to see politicians regulate financial markets in general and to sanction perceived misbehaviour from the past. Secondly, dark pools challenge some of the essential features of financial markets that presumably preserve general welfare: investor protection, best execution and transparency.

Figure 01: On-exchange, off-exchange and dark pool trading. EstimatedFigure 01: On-exchange, off-exchange and dark pool trading. Estimated

Figure 01: On-exchange, off-exchange and dark pool trading.

The Swiss perspective

In Switzerland, a new body of regulation called the Financial Market Infrastructure Act (FMIA) entered into force on the 1st of January 2016. The FMIA addresses many issues, dark pools amongst them. Swiss law is fairly similar to the new European regulation, MiFID 2. It is likely that judicial interpretations of the FMIA will respect the intentions of MiFID 2 in order to avoid the EU sanctioning Switzerland by excluding it from EU financial markets. Such an outcome would be inconceivable for Switzerland given the importance of the financial sector to the overall economy.

The FMIA removes the distinction between the generic terms 'exchanges' and 'exchange-like' platforms by creating a new category named 'trading venues'. This is considered part of the 'Market Infrastructure' and is divided into three categories: Regulated markets (RM), Multilateral Trading Facilities (MTF) and Organised Trading Facilities (OTF). The latter is a catch-all term, designed to include a wider range of previously excluded participants, including dark pools. In practice, the Swiss market supervisor, the FINMA, will have the discretion to categorize a given trading venue.

Dark pools will then be considered as either MTFs, OTFs or SIs (Systematic Internalizers - which are not considered to be part of the Market Infrastructure) depending on their specific activities. Consequently, dark pools will need to meet new compliance requirements. Firstly, they will require authorisation to practice as an investment firm. Secondly, they will be subject to capital requirements. Thirdly, dark pools users might need to create a Self-Regulatory Organisation (SRO) in order to assume surveillance and self-regulation best practice. In this regard, we note that (unlike in the EU) important self-regulation features are preserved under Swiss law. For instance, dark pools will still be authorized to have their own discretionary rule-set on their own venue.

The EU perspective

In Europe, the adoption of MiFID 2 in January 2018 will be a game changer for dark pools. The regulation classifies some previously excluded dark pools as Market Infrastructure. Additionally it significantly increases transparency requirements and extends the scope of regulatory surveillance.

Regarding the surveillance, scope and transparency requirements: MiFID 2 foresees that pre-trade and post-trade transparency requirements will basically apply by default to dark pools. They will have to submit transaction information on a continuous, near real-time basis relating to price, volume, time and direction of trade. We note that the transparency requirements are roughly similar between the types of venues considered, however they may differ according to the kind of instruments observed (e.g. equity, equity-like, non-equity).

The pre-trade transparency disclosure is not absolute. MiFID 2 foresees exceptions (via the use of a waiver), notably for large-in-scale orders. This waiver aims at preserving the original function of dark pools. Nevertheless, this waiver is itself not absolute. Even if an order is waived, MiFID 2 also introduces a system of 'double volume caps'. The volume cap is calculated on an instrument-by-instrument basis and aims at setting a yearly upper limit for the amount of trading happening in dark pools. In brief, the first volume cap is set at 4% of the overall amount of trading across all trading venues in the EU and it is calculated on single trading venue basis. The second volume cap is set at 8% of the overall amount of trading across all trading venues in the EU, and it is calculated across all trading venues. Interested readers may refer to Automated Trader Issue 39, pages 24-25, to find out more about double volume caps and MiFID 2 in general.

Post-trade transparency will be mandatory for all trading venues. The price, volume and time of transactions will have to be disclosed as close to real-time as technically possible. ESMA allows for a maximum delay of 15 minutes, with this window shrinking to five minutes starting in 2020. Nevertheless MiFID 2 foresees an exception with the possibility to use a deferred publication in certain circumstances.

Finally, MiFID 2 is extended to include new types of instruments in its reporting requirements. The equity, equity-like and non-equity instruments will now be under a common reporting obligation, albeit with slightly different modalities depending on the exact type of instrument on which the trade is being reported.

Figure 02: Average Trade Size

Figure 02: Average Trade Size

The US perspective

In the US, regulation of dark pools is less stringent than in the EU. A dark pool can be categorized as either a broker-dealer or an Alternative Trading System (ATS). Most are considered to be ATS and subject to lighter regulation under the Regulation National Market System (RegNMS), the Regulation Alternative Trading System (RegATS) and the Regulation Systems Compliance and Integrity (RegSCI). In comparison, broker-dealers must be licensed by FINRA and are subject to heavier regulation. The main difference between US and EU regulation is the lower degree of transparency required under US law.

Currently, at the pre-trade transparency level, broker-dealers must comply with pre-trade transparency requirements. Contrast this with the rules for ATS: RegATS says that a trade must only be reported whenever it exceeds 5% of the average daily trading volume of a publicly listed single stock. However, this threshold is not frequently exceeded. Consequently, a recent proposal aims to lower the reporting threshold to 0.25% in order to enhance transparency. A second proposal aims to introduce a 'trade at' rule, meaning that a stock traded in a dark pool must be traded at a price that is equal to or better than the price available on the public markets. The ultimate goal of these proposals is to diminish the attractiveness of dark pools and bring more trading into the regulatory light, so to speak.

At the post-trade transparency level, regulations differ between broker-dealers and ATS. For broker-dealers, the Financial Industry Regulatory Authority (FINRA) requires trading information to be reported on a delayed basis (up to 15 minutes) to the Trade Reporting and Compliance Engine (TRACE). For ATS, FINRA publishes the information about trades immediately after they have been reported to the consolidated tape, named the Market Information Data Analytic System (MIDAS). FINRA in turn publishes this information with a delay of at least two weeks to the public.

Finally, it is worth noting that the US is currently mulling over changes that require an ATS to disclose a lot more detail about their operations, volumes, order types, policies and broker-dealers that they are operated by or affiliated with. Again, the emphasis is to put the dark pools into the same spotlight that regulated exchanges already find themselves in.


As dark pools have become increasingly important for equity trading, regulators have taken notice. New regulations aim to ensure that dark pools are treated more like traditional marketplaces, such as public exchanges, thereby avoiding 'regulatory arbitrage' between venues. Though regulators are trying to strike a balance between increasing transparency and preserving the original function of dark pools, volume caps under MiFID 2 limit the expansion of unlit markets. Increased transparency means significant reporting obligations for marketplaces and end-users alike, increasing the fixed costs of trading and thus discouraging competition. Furthermore, regulators might find themselves unable to effectively use the massive volumes of data they will collecting. Whether the new regulations strike the appropriate balance between cost and benefit will only become clear in time.


Ernst & Young
The world of financial instruments is more complex.
Time to implement change. Capital markets reform: MiFID II

Freshfields Bruckhaus Deringer LLP
MiFID 2: Markets - pre and post trade transparency

Jaccard, Gabriel
High Frequency Trading: The Technological Puzzle, in: Uplaw

PricewaterhouseCoopers LLP
An objective look at High-frequency trading and dark pools