LONDON Fund managers are trading more assets on private exchanges known as dark pools, a growing trend that clashes with regulators' mission to improve financial market transparency.
Dark pools are electronic trading networks that allow investors to buy and sell stocks anonymously, in private deals so other shareholders are not aware of the trades. Some of the details are made public but only after the market has closed.
That contrasts with public exchanges such as the London Stock Exchange where large buyers and sellers are required to identify themselves and stock prices reflect trading activity in real time, throughout the day.
Some investors are shifting business away from public exchanges because they feel these offer little chance to negotiate cheaper bulk buying or to sell without triggering sell-offs that can cut the price they fetch for their assets.
"If you want to buy one suit or one car, you see one price. If you want to buy 100 suits or 100 cars, you approach the seller to discuss another price. Who benefits from that? The end investors," Vincent Dessard, regulatory policy advisor at the European Fund and Asset Management Association trade body, said.
Thomson Reuters and Markit data suggests the volume of dark trading rose for the fifth consecutive month in September, accounting for 5.84 percent of all European share trade, more than double the 2.8 percent volume recorded in September 2011.
The rising popularity of off-exchange activity has sparked fresh debate over proposed caps on dark pool trading in the next revision of the European Union's (EU) Markets in Financial Instruments Directive (MiFID), under discussion in Brussels.
Policymakers want to cap daily dark trading at 4 percent of total trading in each stock in the EU, and total aggregated dark pool transactions at 8 percent of all European trade.
They worry that transactions capable of destabilising markets could go undetected unless limits are introduced. They also fear users are draining liquidity from public exchanges, making it harder for other investors to value stocks accurately.
Anyone can use these pools if they have membership and fees are typically lower than trading stocks using traditional stockbrokers. The biggest users of these networks are large fund managers and banks who regularly trade large volumes of stocks.
Supporters of off-exchange trading say removing the option of buying and selling shares privately will make large portfolios more costly to manage and potentially hurt performance of investment funds and pensions.
"This will hurt liquidity but more specifically, it will hurt European citizens. When the price for one security is set, you are removing the capacity for an asset manager to negotiate something lower," Dessard added.
Thomson Reuters aggregates all trade data on 'dark' Multilateral Trading Facilities (MTFs) and platforms provided by BATS-Chi X, London Stock Exchange-operated Turquoise (LSE.L) and Liquidnet.
MTFs match buyers and sellers anonymously and publish the trade on data feeds available to all market users after the market has closed.
The Markit data, meanwhile, only gives a snapshot of aggregate trade at six of the large Broker Crossing Systems, where bank traders match up clients privately but only report the trades in a job lot at the close, without breaking down the stocks concerned.
Without more comprehensive data, critics say it is tough to establish whether dark pools help or hinder the broader market, or make public exchanges less efficient in discovering price. This could render new rules challenging to enforce.
"Because the data isn't really out there to understand precisely what is the percentage of market share of dark pools ... It's very hard to know if we're at that cap or beyond it," Mark Goodman, head of quantitative electronic services, Europe at Societe Generale, said.
Echoing this, Mark Hemsley, CEO of BATS Chi-X Europe, said: "There is logically a point where moving flow into the dark is detrimental to the price-formation process but I have yet to see a study of the European market that says what that number is."
This lack of clarity in the UK contrasts sharply with Canada and Australia, where more data is available, allowing academics to research what constitutes 'good' or 'bad' dark trading.
In Asia and the United States, the volumes of shares traded using dark pools is even harder to track, analysts say, mainly because bank traders and other dark pool providers are not subject to the same strict post-trade reporting rules as European peers.
Professor Carole Comerton-Forde from the University of Melbourne published research in July entitled 'Dark trading and price discovery' and found only high levels of specific types of dark trading were damaging to Australia's stock market. She is confident the results would be similar in Europe.
When a pension fund or investor wants to sell a large number of shares also known as a 'block' trade, dark trading was "absolutely essential", she said, and could be done in unlimited quantities without hurting the broader market.
Only the migration of large volumes of smaller trades to the dark pools was more "problematic", Comerton-Forde said, as they traditionally accounted for much of the liquidity on exchanges.
"When the trade's done in the dark, it means we're not seeing that order flow on the exchange and observing order flow is very helpful in terms of understanding prices," she said.
When dark trading reached 25 percent of all trading in Australia, local regulators decided to act, forcing anyone who wanted to trade in the dark to be at the on-exchange price.
The volume of dark trades below block size have now dropped by half to around 5 percent of total market activity, she said.
Market participants say demand from big investors to trade large volumes of shares away from the public stock exchanges will remain even if MiFID 2, goes through as proposed.
"Assuming everyone will stop trading in the dark and automatically go to trading on lit exchanges is just fantasy," said Rebecca Healey, senior analyst at consultant TABB Group, adding that much of that trade had never been on-exchange.
"The traditional exchanges are very worried about the amount of dark activity that is happening but the irony is that that's not necessarily trading they would have interacted with before."
The fledgling European economic recovery is tempting investors back into European equities, a Reuters Poll shows, but market volumes remain depressed after years of turgid activity during the debt crisis, forcing fund managers to consider all options in their quest for liquidity.
For Derek Mitchell, senior equities fund manager at Royal London Asset Management, the trading opportunities provided by dark pools are difficult to match elsewhere.
"Our old dealer has just retired and we've just recruited someone ... who has much greater experience of using dark pools. Since he arrived we've been using them more and benefiting from his expertise...The liquidity you can access is hard to ignore."