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.
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.
- “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.
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