Financial regulators probe dark pools

By Nicole Bullock. This article originally appeared on the Financial Times website, on September 16th, 2014

Dark pools are squarely in the spotlight. Following the publication of Flash Boys, which claims that the US equity market is rigged, scrutiny has intensified.

The fallout from Michael Lewis’s book comes on top of a string of technical snafus in recent years, including the Flash Crash of 2010. In June, Eric Schneiderman, the New York State attorney-general, brought a lawsuit against Barclays alleging the UK bank fraudulently misled customers of its dark pool about the extent of high-frequency trading.

His is the most high-profile stance yet taken but around the world regulators have been steadily growing concerned that the fragmentation of markets and move to electronic trading has created a system they can no longer adequately oversee.

“Alternative Trading System [ATS] volumes have increased dramatically to between 35 and 40 per cent of the [US] market. That is raising questions about liquidity and transparency, especially following the financial crisis, which has caused regulators, market participants and others to be worried about shadowy types of markets,” says Charles Whitehead, a law professor at Cornell Law School.

While the Securities and Exchange Commission has kicked off a broad examination of US equity market structure, it is facing the same issues that other regulators around the world have confronted.

Some countries have either introduced or are developing rules that are both highly prescriptive and more nuanced to curtail dark pool trading. The question is to what extent the US, the world’s largest equity market, will follow suit.

Hong Kong has proposed restricting access to dark pools to institutional investors and banning retail investors. Australia and Canada have taken a more qualitative approach. They back a system that relies on so-called price improvement, which means that the dark pool must offer a better price than on an exchange in order for the trade to be routed there.

Europe’s regulators have gone further, agreeing to cap volumes on trading securities in dark pools. They want to limit dark pool trading to 4 per cent per venue and 8 per cent across the region per month.

But the incoming rules are controversial. Critics worry how regulators will collect the data from approximately a dozen platforms and argue that caps will raise costs for investors by preventing them from getting the best prices for their trades.

“In Europe, the restrictions are pretty significant. There is nothing else like that in major western markets,” says Justin Schack, managing director at Rosenblatt Securities. “US regulators are focused more broadly on the conflicts of interest embedded in what has become a complex market structure over the past two decades. There are 11 exchanges and two dozen major off-exchange destinations and each has a different rule set and fee structure.”

The Financial Industry Regulatory Authority in the US this year began publishing aggregate information on trading volumes for ATSs. Some dark venues have also begun to voluntarily publish details about how they work. Nevertheless, they represent only part of the total volume since some dark pools are unregistered. The SEC supports expanding the trading volume disclosure to off-exchange market makers and other broker dealers, as well as making more information about how dark pools work publicly available.

But the US regulator has bigger plans. “Dark pools are a big part . . . but it is also the lit markets,” says Mr Schack. “The complexity gives brokers opportunities to route orders according to their own economic interests rather than their clients.’ The [SEC] appears to be prioritising transparency and giving institutional investors the tools they need to identify and manage these conflicts.”

One consequence of the Australian and Canadian rules is that trading flow has leaked away from dark pools to the incumbent exchange. In Canada, only 3 per cent of equity volume was executed by dark pools compared with nearly 6 per cent in September 2012, the month before the rules were introduced. Executives expect a similar outcome when the rules in Europe are introduced in 2017.

“You must balance dark and lit liquidity,” said Larry Tabb, chief executive of Tabb Group. “If the markets become too dark, the price discovery breaks down and you wind up with a less efficient marketplace.”


Proliferation: Venues have strayed from original purpose

Dark pools are menacing-sounding places where trades are executed away from an exchange. They bring both benefits and, increasingly, risks.

These venues were founded with the idea of providing institutional investors with a way to trade large blocks of shares without disrupting the overall market and, in turn, achieving less favourable execution. Prices are posted only after the trade has been done.

Many big investment banks, such as Credit SuisseBarclays and Goldman Sachs, operate dark pools.

In the US in July, more than a third of equity volume occurred off-exchange with about 16 per cent in dark pools, according to Rosenblatt Securities.

Regulators, market participants and observers fear dark pool proliferation means that public markets may no longer show a true picture of prices. The size of trades in dark pools has also dropped, indicating that in practice, they have ventured far from their original purpose.

Additional reporting by Philip Stafford in London

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