• <div class="header-image" style="background-image: url(/live/image/gid/4/2611_Header_V6N2_web_4.rev.1518551584.jpg);">​</div><div class="header-background-color"/>

Dark Pool Regulation

December 30, 2014

Scrutiny of dark pools escalated recently after New York Attorney General Eric Schneiderman filed a lawsuit against Barclays in June. Barclays was accused of misleading clients on the number of high-frequency traders in their dark pool as well as of giving predatory traders unfair advantages. Trading volume in Barclays’ dark pool fell by 79 percent in the week after the New York Attorney General’s lawsuit was filed, and other banks operating dark pools have since been drawn into the controversy as investigations widen (“Barclays”). Given all the attention, dark pools have gained an ominous reputation.

By Kevin You, SAS ’17

Dark pools are private exchanges for trading securities. Unlike public stock exchanges, dark pools are anonymous and orders are not reported until after trades are completed. Records of trades are only released to the tape after a delay, allowing investors to hide their orders. Dark pools typically benefit large institutional investors who want to unload large orders without triggering a market response. These investors do not want news of their order to adversely affect prices while they are still executing the trade.

40 percent of all U.S. trades are now conducted off of public exchanges, up from just 16 percent six years ago (Popper). Dark pools themselves account for 14 percent of the total U.S. trading volume. There are several reasons for the expansion of dark pools. According to The Economist, algorithmic trading and new computer programs have made it more difficult for large institutional investors to disguise their orders on public exchanges (“Shining”). Large institutional investors adopt various strategies to prevent news of their orders from leaking to the public, such as dividing large orders into smaller slices to blend into the general market activity. Computer programs are now more adept at detecting these strategies, increasing the risk that other investors like high-frequency trading firms can take advantage of these orders.

Percentage of Stocks traded outside of official exchanges 

Lower transaction costs are another incentive to use dark pools, as brokerages can avoid paying exchange fees on each trade. Brokers can match buyers and sellers among their own clients to complete trades and further reduce transaction costs. Dark pools also tend to be utilized more heavily in times of low volatility. When volatility is high, investors prefer to complete their trades quickly and reliably, leading them to choose the relative safety of public exchanges (Popper). The benefits of dark pools are more appealing when volatility is low. With the Chicago Board Options Exchange Volatility Index falling to a seven year low in June, more and more investors have turned to off-exchange trading (Mamudi).

The need to regulate dark pools is now more pressing than ever. With such a large proportion of trading volume occurring off of public exchanges, regulators are concerned that it will be difficult to properly price securities. Prices no longer reflect the actual demand for a security if a significant proportion of its trades occur in opaque venues. A study by the University of Melbourne concluded that price discovery for a security begins to erode when more than 10 percent of its trades occur off-exchange (McCrank). This is especially troubling since dark pools base their prices on trades in public exchanges; if those prices are skewed, the dark pools’ prices will be as well.

Lack of transparency in dark pools is a major concern for regulators. While public exchanges disclose orders to the public as soon as they are made, dark pools are reluctant to reveal unfilled orders. However, dark pools do send “indicators of interest” to let certain brokers know what securities are being ordered. This creates a two-tiered market in which some participants have privileged knowledge of prices and orders while the public does not. Regulators have proposed rules in the past requiring indicators of interest to be treated like public quotations, but so far no rules have been implemented. Public exchanges are required to treat customers equally, but dark pools can currently choose which firms have access and can charge different prices to each customer. Since many dark pools are run by banks, regulators are worried that banks could improperly share information about dark pool trading activity to their own traders or sell that information to outside clients (Popper).

Regulators are considering a number of new rules for dark pools to increase transparency. One rule under consideration would require alternative trading systems to report weekly volume and number of trades for each security, as well as where each trade was executed. Currently, dark pool disclosures only reveal that a trade was completed off of public exchanges. They do not specify which dark pool completed which trade, limiting the public’s ability to assess stock liquidity and dark pool trading activity (McCrank). The proposed rule would force dark pools to adhere to a similar level of post-trade transparency as public exchanges, including public reports on completed trades. A number of other rules, such as requiring brokerages to disclose routing decisions for large institutional investors, could also be implemented to improve transparency (Patterson).

Another proposed reform is the trade-at rule, which would require brokerages and dark pools to route orders to public exchanges unless they can provide a meaningfully better price. Similar rules already exist in Canada and Australia, and the implementation of this rule in the U.S. would be a significant challenge for dark pools to overcome. The trade-at rule will be tested in a pilot alongside a “tick size” rule. Stock prices on public exchanges are listed in one-penny increments, but dark pools have been allowing trades at fractions of a penny. The new tick size rules would allow public exchanges to complete trades at fractions of a penny, pushing trades back to public exchanges.

Recent controversy has drawn renewed attention to dark pools. Regulators are beginning to take steps to address the lack of transparency in dark pools, and new rules could expand trading disclosures and improve public access to dark pool information.

 

References:

  • “Barclays’ Dark Pool Trading Volume Falls after Lawsuit.” Reuters. Thomson Reuters, 21 July 2014. Web.
  • Mamudi, Sam. “Dark Pools Take Larger Share of Trades Amid SEC Scrutiny.” Bloomberg.com. Bloomberg, 13 June 2014. Web.
  • McCrank, John. “U.S. Securities Watchdog Proposes New Rules for Dark Pools.” Reuters. Thomson Reuters, 01 Oct. 2013. Web.
  • Patterson, Scott. “SEC Chairman Targets Dark Pools, High-Speed Trading.” The Wall Street Journal. 6 June 2014. Web.
  • Popper, Nathaniel. “As Market Heats Up, Trading Slips Into Shadows.” The New York Times. 31 Mar. 2013. Web.
  • “Shining a Light on Dark Pools.” The Economist. 18 Aug. 2011. Web.
Student Blog Disclaimer
  • The views expressed on the Student Blog are the author’s opinions and don’t necessarily represent the Penn Wharton Public Policy Initiative’s strategies, recommendations, or opinions.

PENN WHARTON PPI
RESOURCE SPOTLIGHT:

  • <h3>Internal Revenue Service: Tax Statistics</h3><p><img width="155" height="200" alt="" src="/live/image/gid/4/width/155/height/200/486_irs_logo.rev.1407789424.jpg" class="lw_image lw_image486 lw_align_left" srcset="/live/image/scale/2x/gid/4/width/155/height/200/486_irs_logo.rev.1407789424.jpg 2x" data-max-w="463" data-max-h="596"/>Find statistics on business tax, individual tax, charitable and exempt organizations, IRS operations and budget, and income (SOI), as well as statistics by form, products, publications, papers, and other IRS data.</p><p> Quick link to <strong>Tax Statistics, where you will find a wide range of tables, articles, and data</strong> that describe and measure elements of the U.S. tax system: <a href="http://www.irs.gov/uac/Tax-Stats-2" target="_blank">http://www.irs.gov/uac/Tax-Stats-2</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>MapStats</h3><p> A feature of FedStats, MapStats allows users to search for <strong>state, county, city, congressional district, or Federal judicial district data</strong> (demographic, economic, and geographic).</p><p> Quick link: <a href="http://www.fedstats.gov/mapstats/" target="_blank">http://www.fedstats.gov/mapstats/</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>National Bureau of Economic Research (Public Use Data Archive)</h3><p><img width="180" height="43" alt="" src="/live/image/gid/4/width/180/height/43/478_nber.rev.1407530465.jpg" class="lw_image lw_image478 lw_align_right" data-max-w="329" data-max-h="79"/>Founded in 1920, the <strong>National Bureau of Economic Research</strong> is a private, nonprofit, nonpartisan research organization dedicated to promoting a greater understanding of how the economy works. The NBER is committed to undertaking and disseminating unbiased economic research among public policymakers, business professionals, and the academic community.</p><p> Quick Link to <strong>Public Use Data Archive</strong>: <a href="http://www.nber.org/data/" target="_blank">http://www.nber.org/data/</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>National Center for Education Statistics</h3><p><strong><img width="400" height="80" alt="" src="/live/image/gid/4/width/400/height/80/479_nces.rev.1407787656.jpg" class="lw_image lw_image479 lw_align_right" data-max-w="400" data-max-h="80"/>The National Center for Education Statistics (NCES) is the primary federal entity for collecting and analyzing data related to education in the U.S. and other nations.</strong> NCES is located within the U.S. Department of Education and the Institute of Education Sciences. NCES has an extensive Statistical Standards Program that consults and advises on methodological and statistical aspects involved in the design, collection, and analysis of data collections in the Center. To learn more about the NCES, <a href="http://nces.ed.gov/about/" target="_blank">click here</a>.</p><p> Quick link to NCES Data Tools: <a href="http://nces.ed.gov/datatools/index.asp?DataToolSectionID=4" target="_blank">http://nces.ed.gov/datatools/index.asp?DataToolSectionID=4</a></p><p> Quick link to Quick Tables and Figures: <a href="http://nces.ed.gov/quicktables/" target="_blank">http://nces.ed.gov/quicktables/</a></p><p> Quick link to NCES Fast Facts (Note: The primary purpose of the Fast Facts website is to provide users with concise information on a range of educational issues, from early childhood to adult learning.): <a href="http://nces.ed.gov/fastfacts/" target="_blank">http://nces.ed.gov/fastfacts/#</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>NOAA National Climatic Data Center</h3><p><img width="200" height="198" alt="" src="/live/image/gid/4/width/200/height/198/483_noaa_logo.rev.1407788692.jpg" class="lw_image lw_image483 lw_align_left" srcset="/live/image/scale/2x/gid/4/width/200/height/198/483_noaa_logo.rev.1407788692.jpg 2x, /live/image/scale/3x/gid/4/width/200/height/198/483_noaa_logo.rev.1407788692.jpg 3x" data-max-w="954" data-max-h="945"/>NOAA’s National Climatic Data Center (NCDC) is responsible for preserving, monitoring, assessing, and providing public access to the Nation’s treasure of <strong>climate and historical weather data and information</strong>.</p><p> Quick link to home page: <a href="http://www.ncdc.noaa.gov/" target="_blank">http://www.ncdc.noaa.gov/</a></p><p> Quick link to NCDC’s climate and weather datasets, products, and various web pages and resources: <a href="http://www.ncdc.noaa.gov/data-access/quick-links" target="_blank">http://www.ncdc.noaa.gov/data-access/quick-links</a></p><p> Quick link to Text & Map Search: <a href="http://www.ncdc.noaa.gov/cdo-web/" target="_blank">http://www.ncdc.noaa.gov/cdo-web/</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>USDA Nutrition Assistance Data</h3><p><img width="180" height="124" alt="" src="/live/image/gid/4/width/180/height/124/485_usda_logo.rev.1407789238.jpg" class="lw_image lw_image485 lw_align_right" srcset="/live/image/scale/2x/gid/4/width/180/height/124/485_usda_logo.rev.1407789238.jpg 2x, /live/image/scale/3x/gid/4/width/180/height/124/485_usda_logo.rev.1407789238.jpg 3x" data-max-w="1233" data-max-h="850"/>Data and research regarding the following <strong>USDA Nutrition Assistance</strong> programs are available through this site:</p><ul><li>Supplemental Nutrition Assistance Program (SNAP) </li><li>Food Distribution Programs </li><li>School Meals </li><li>Women, Infants and Children </li></ul><p> Quick link: <a href="http://www.fns.usda.gov/data-and-statistics" target="_blank">http://www.fns.usda.gov/data-and-statistics</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>Federal Reserve Economic Data (FRED®)</h3><p><strong><img width="180" height="79" alt="" src="/live/image/gid/4/width/180/height/79/481_fred-logo.rev.1407788243.jpg" class="lw_image lw_image481 lw_align_right" data-max-w="222" data-max-h="97"/>An online database consisting of more than 72,000 economic data time series from 54 national, international, public, and private sources.</strong> FRED®, created and maintained by Research Department at the Federal Reserve Bank of St. Louis, goes far beyond simply providing data: It combines data with a powerful mix of tools that help the user understand, interact with, display, and disseminate the data.</p><p> Quick link to data page: <a href="http://research.stlouisfed.org/fred2/tags/series" target="_blank">http://research.stlouisfed.org/fred2/tags/series</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>The World Bank Data (U.S.)</h3><p><img width="130" height="118" alt="" src="/live/image/gid/4/width/130/height/118/484_world-bank-logo.rev.1407788945.jpg" class="lw_image lw_image484 lw_align_left" srcset="/live/image/scale/2x/gid/4/width/130/height/118/484_world-bank-logo.rev.1407788945.jpg 2x, /live/image/scale/3x/gid/4/width/130/height/118/484_world-bank-logo.rev.1407788945.jpg 3x" data-max-w="1406" data-max-h="1275"/>The <strong>World Bank</strong> provides World Development Indicators, Surveys, and data on Finances and Climate Change.</p><p> Quick link: <a href="http://data.worldbank.org/country/united-states" target="_blank">http://data.worldbank.org/country/united-states</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>Congressional Budget Office</h3><p><img width="180" height="180" alt="" src="/live/image/gid/4/width/180/height/180/380_cbo-logo.rev.1406822035.jpg" class="lw_image lw_image380 lw_align_right" data-max-w="180" data-max-h="180"/>Since its founding in 1974, the Congressional Budget Office (CBO) has produced independent analyses of budgetary and economic issues to support the Congressional budget process.</p><p> The agency is strictly nonpartisan and conducts objective, impartial analysis, which is evident in each of the dozens of reports and hundreds of cost estimates that its economists and policy analysts produce each year. CBO does not make policy recommendations, and each report and cost estimate discloses the agency’s assumptions and methodologies. <strong>CBO provides budgetary and economic information in a variety of ways and at various points in the legislative process.</strong> Products include baseline budget projections and economic forecasts, analysis of the President’s budget, cost estimates, analysis of federal mandates, working papers, and more.</p><p> Quick link to Products page: <a href="http://www.cbo.gov/about/our-products" target="_blank">http://www.cbo.gov/about/our-products</a></p><p> Quick link to Topics: <a href="http://www.cbo.gov/topics" target="_blank">http://www.cbo.gov/topics</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>HUD State of the Cities Data Systems</h3><p><strong><img width="200" height="200" alt="" src="/live/image/gid/4/width/200/height/200/482_hud_logo.rev.1407788472.jpg" class="lw_image lw_image482 lw_align_left" srcset="/live/image/scale/2x/gid/4/width/200/height/200/482_hud_logo.rev.1407788472.jpg 2x, /live/image/scale/3x/gid/4/width/200/height/200/482_hud_logo.rev.1407788472.jpg 3x" data-max-w="612" data-max-h="613"/>The SOCDS provides data for individual Metropolitan Areas, Central Cities, and Suburbs.</strong> It is a portal for non-national data made available through a number of outside institutions (e.g. Census, BLS, FBI and others).</p><p> Quick link: <a href="http://www.huduser.org/portal/datasets/socds.html" target="_blank">http://www.huduser.org/portal/datasets/socds.html</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>The Penn World Table</h3><p> The Penn World Table provides purchasing power parity and national income accounts converted to international prices for 189 countries/territories for some or all of the years 1950-2010.</p><p><a href="https://pwt.sas.upenn.edu/php_site/pwt71/pwt71_form.php" target="_blank">Quick link.</a> </p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>Federal Aviation Administration: Accident & Incident Data</h3><p><img width="100" height="100" alt="" src="/live/image/gid/4/width/100/height/100/80_faa-logo.rev.1402681347.jpg" class="lw_image lw_image80 lw_align_left" srcset="/live/image/scale/2x/gid/4/width/100/height/100/80_faa-logo.rev.1402681347.jpg 2x, /live/image/scale/3x/gid/4/width/100/height/100/80_faa-logo.rev.1402681347.jpg 3x" data-max-w="550" data-max-h="550"/>The NTSB issues an accident report following each investigation. These reports are available online for reports issued since 1996, with older reports coming online soon. The reports listing is sortable by the event date, report date, city, and state.</p><p> Quick link: <a href="http://www.faa.gov/data_research/accident_incident/" target="_blank">http://www.faa.gov/data_research/accident_incident/</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>