Diving into Dark Pools: An Analysis of Hidden Liquidity with Regard to the Proposed Markets in Financial Instruments Directive

AuthorGeorge O'Malley
PositionSenior Sophister, LLB Candidate Trinity College Dublin
© 2014 George O’Malley and Dublin University Law Society
Global equity markets have been transformed in the last decade. The 2008
economic crises shook financial markets to their core and paved the way
for sweeping reforms, particularly in relation to securities regulation.
Other factors, such as advancements in technology, have led to the advent
of algorithmic and high frequency trading and the fragmentation of the
securities markets.
1 Securities exchanges like the NYSE, LSE and
NASDAQ once enjoyed a large market share, but this share is being
eroded as venues such as alternative trading systems (ATS),2 known in
Europe as multilateral trading facilities (MTFs), 3 have become
Senior Sophister, LLB Candidate Trinity College Dublin. The author would like to thank
Professor Deirdre Ahern, School of Law, Trinity College Dublin and Caoimhe Stafford,
Senior Editor, Trinity College Law Review for their comments and insights on earlier drafts.
Any errors or omissions are the author’s own.
1 Richard Finger, “High Frequency Trading: Is It A Dark Force Against Ordinary Human
Traders And Investors?” Forbes 30 September 2013.
2 An ATS is any approved, non-exchange trading venue that is registered with the US SEC.
Rule 300(a) of the Regulation of Exchanges and Alternative Trading Systems defines it as
“any organisation, association, person, group of persons, or system: (1) That constitutes,
maintains, or provides a market place or facilities for bringing together purchasers and sellers
of securities or for otherwise performing with respect to securities the functions commonly
performed by a stock exchange within the meaning of § 240.3b-16 of this chapter; and (2)
That does not: (i) Set rules governing the conduct of subscribers other than the conduct of
such subscribers' trading on such organisation, association, person, group of persons, or
system; or (ii) Discipline subscribers other than by exclusion from trading. See Code of
Federal Regulations, Title 17, Commodities and Securities Exchanges, [hereinafter 17 CFR],
s. 242.300.
3 An MTF is defined as a “multilateral system operated by an investment firm or market
operator, which brings together multiple third-party buying and selling interests in financial
instruments in the system and in accordance with non-discretionary rules.” See Directive
2004/39/EC of 21 April 2004 on markets in financial instruments amending Council
2014] Dark Pools 95
increasingly popular. These ATS have given investors the option of
choosing new pools of liquidity, allowing them to move away from the
more regulated exchanges. These venues are able to cater for dark,
anonymous trading, as they do not have the same transparency
requirements as traditional exchanges. At the time of writing, the
European Parliament, European Commission and the Council of the
European Union have just reached agreement on the level one text for the
4 which is set to introduce
far reaching regulatory changes to the nature of dark pools in European
equity markets.5
First, this article considers dark pools: what they are and why they
are gaining an increasingly important role in global equities markets, and
indeed in markets for other securities. Secondly, the article examines
whether dark pools benefit the market in respect of a number of factors:
liquidity, market impact and information leakage, structure, savings and
price improvement, information asymmetry and finally, price discovery.
Thirdly, it examines European Union legislation, particularly the
relationship between the original Markets in Financial Instruments
Directive (‘MiFID’) and MiFID II and how this has influenced dark pool
trading in European securities markets. The article further provides a brief
consideration of other jurisdictions, namely Canada and Australia.
Fourthly, it critically analyses MiFID II and in doing so, identifies whether
the perceived regulatory response to dark pools will be effective. Fifthly, it
examines the role and future of dark pool trading. Finally, it finishes with
some concluding remarks and recommendations.
Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/EC of the European Parliament
and of the Council and repealing Council Directive 93/22/EEC [2004] OJ L145/1, amended
by Directive 2006/31/EC of the European Parliament and Council, OJ L114/60, Article 4(15).
4 Proposal for a Directive of the European Parliament and of the Council of 20 October 2011
on markets in financial instruments repealing Directive 2004/39/EC of the European
Parliament and of the Council 2011/0298.
5 The level one text was agreed on 14 January 2014. See Phillip Stafford and Alex Barker,
“Europe in Securities Market Shake-up” Financial Times 15 January 2014.
96 Trinity College Law Review [Vol 17
I. Dark Pools
A. Definition and Background
In essence, dark pools could be defined as equity trading systems that do
not publicly display orders.
6 Erik Banks provides a thorough and
comprehensive explanation of the term, noting that a dark pool is a “venue
or mechanism containing anonymous, non-displayed trading liquidity that
is available for execution.”7 A further analysis of these individual terms
reveals the following: anonymous, non-displayed trading liquidity is order
flow submitted confidentially that does not appear on public order books; a
venue is any electronic platform involved partly or solely in housing non-
displayed liquidity; a mechanism is any structure or participant that houses
non-displayed liquidity; and execution is the ability to buy or sell through
the submission of an order.8 Thus, it is clear that the defining characteristic
of dark pools is their anonymity, with trades being executed in the dark,
largely invisible to the wider market. For the purposes of this article,
Banks’ definition of a dark pool will be preferred.
B. Dark Pool Venues
Dark liquidity is not in itself a new phenomenon. Historically, it has been
used in situations of upstairs trading,9 in the OTC markets,10 and in the
internalised order flows of broker-dealer firms. However, dark pools of
liquidity only became a popular alternative to traditional exchanges in the
6 Haoxiang Zhu, “Do Dark Pools Harm Price Discovery?” (updated 16 November 2013)
Review of Financia l Studies (forthcoming 2014), at 1.
7 Erik Banks, Dark Pools: The Structur e and F uture of Off-Exchange Trading and Liquidity
(Palgrave Macmillan, 2010), at 3.
8 Ibid.
9 Upstairs trading generally refers to a situation where a trade in a listed stock is not executed
through the listing exchange. Historically, in an upstairs trade, buyers and sellers would
negotiate the price and conditions of the trade in the upstairs rooms of a brokerage firm.
Today, upstairs trading typically makes use of technology to negotiate the price and
conditions of a trade. See Investopedia, Upstairs Trade Definition
(visited 31 January 2014).
10 OTC refers to over-the-counter markets and is carried out by market makers using inter-
dealer quotation services. OTC stocks are generally made up of stocks that do not meet the
requirements for listing on a national exchange. See Investopedia, Over-The-Counter (OTC)
Definition (visited 31 January 2014).

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