SEC Proposals Increase Dark Pool Transparency
But Trades $200K-Plus Would Be Exempted From Rules
November 23, 2009
Mutual funds and large institutional investors are being spared from a new Securities and Exchange Commission proposal to reign in the growing use of dark pools to hide trading information, since only trades smaller than $200,000 would be exposed.
While industry groups like the Investment Company Institute promote the usefulness and necessity of dark trading for some market participants, regulators at the SEC and other regulators are concerned that too much unregulated and unmonitored activity is occurring.
"We won't have a true understanding of supply and demand if everyone is hiding orders and nothing is posted," said Kevin Cronin, managing director and global head of equity trading at Invesco, speaking at an ICI-sponsored webinar last week on dark pools.
The number of dark pools trading on major U.S. stock markets has tripled since 2002, and trading volume in dark pools has risen from 3% to nearly 9% in the past year, mostly due to internal trading between dark markets. The four largest dark pools by volume are Credit Suisse Crossfinder, Goldman Sachs Sigmax, Knight Link and Getco Execution Services, according to a study by Rosenblatt Securities (see chart).
Dark pools are trading venues that don't display liquidity. They can be very beneficial to average investors by allowing mutual funds and large institutional investors an efficient way to make large trades without impacting the market.
"The larger the trade, the greater the risk of an adverse price movement," said Paul Schott Stevens, ICI president and CEO.
Dark exchanges allow investors to test the waters to see if there is another investor on the opposite side of their trade, without revealing their intentions to the public. If there is, the two parties can make the exchange at the price they want and neither party will know the other's identity, "like ships that pass in the night," Cronin said.
Trading in the dark prevents the leakage of trading information and front running of orders, and with virtually no reporting requirements, dark exchanges can provide a low-cost alternative to traditional trading venues.
Traders of all sizes love the idea, and regulatory loopholes intended to improve competition have allowed these dark exchanges to explode in popularity.
"In recent years, a large number of dark pools have entered the markets, and now represent a significant source of liquidity in U.S.-listed stocks," said SEC Chairman Mary Schapiro. "Given the growth of dark pools, this lack of transparency could create a two-tiered market that deprives the public of information about stock prices and liquidity."
Participants in these private pools have access to trading information that other investors do not, and they are able to use prices provided by the publicly displayed markets without contributing their own information, Schapiro said.
The wide spectrum of benefits that come from transparency cannot be underestimated, she said, from promoting public confidence to the insurance of honesty and integrity in financial markets.
"We recognize the reality that large institutional orders can have undue market impacts, but we are very concerned that the networking between dark pools could lead to the creation of dark liquidity and dark exchanges," said Eric Noll, executive vice president of transaction services at Nasdaq.
"The original intent was to facilitate institutional orders without market impact, but dark pools are not contributing to market transparency," Noll said. "What looks like an order should be treated like an order."
The SEC recently proposed regulations to narrow some of these loopholes and is seeking public comments through mid-January. The proposals address three specific concerns. The first is to require actionable Indications of Interest (IOIs) to be treated like quotes and be subject to the same disclosure rules.
IOIs are generally excluded from the definition of "bid" or "offer" and are not subject to quoting requirements, said James Brigagliano, co-acting director of the SEC's Division of Trading and Markets.
"By sending out these actionable IOIs -which function quite similarly to displayed quotations-these dark pools are 'lit' to a select group of market participants and 'dark' with respect to the rest of the public," said SEC Commissioner Elisse Walter. "The result is that substantial information about available trading interest at the best-displayed prices is not being conveyed to all investors.
"Most dark pools, though they may handle large orders, primarily execute trades with small sizes that are more comparable to the average size of trades in the public markets," Walter continued. "These dark pools that primarily match smaller orders account for more than 90% of dark pool trading volume."
Another proposal is to lower the trading threshold for alternative trading systems for displaying best-priced orders. These trading systems are currently required to display best-priced orders to the public when trading volume for a stock is 5% or more. The SEC is proposing to lower that to a volume of 0.25%. As large investors still need to control the information flow concerning their trades, the SEC intends to exempt display requirements for orders of $200,000 or more.
The third proposal covers post-trade transparency, requiring dark pools to publicly identify that it was their pool that executed a trade, the same as for registered exchanges.
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