Dark Pools, Derivatives and HFT Top Buy Side's Regulatory Agenda

As the industry contemplates what's in store in 2010, topping the buy side's list of concerns are dark pool, high-frequency trading and OTC derivatives regulatory reform as well as broader scrutiny of systemic risk. But while buy-side traders fear regulations that reduce liquidity in dark pools and hinder high-frequency trading, they welcome heightened oversight of derivatives.

The buy side is leery of proposed SEC requirements that would force dark pools to make their quotes public at lower volume thresholds and report their trades to the tape in real time. "It's going to be interesting to see how the regulators handle these dark pools. I think it's a little bit unfair and unjust that they go after these guys," a head trader at a hedge fund told us during a follow-up interview in December after Advanced Trading's Buy-Side Trading Summit in November.

One reason why dark pools have become a target for regulators and Congress, he suggested, is the name. "It comes across that there is something sinister, and really it's just another avenue of liquidity that cuts down on the execution costs," the head trader said, insisting that had they named it something else, the SEC would not be probing the private liquidity networks.

In general buy-side attendees at the AT Summit made it clear that they oppose any SEC action that would reduce liquidity in dark pools, including excessive regulation of high-frequency trading. And while regulators have focused on the potential that colocation of HFT shops' black boxes creates an unfair advantage at the expense of mutual funds and individual investors, long-only traders at the AT Summit said they had no interest in moving their algorithms closer to the exchange matching engines. One buy-side trader noted that he didn't care if it took him 41 milliseconds to reach a trading venue's matching engine because speed wasn't his firm's strategy.

Buy-side traders do acknowledge that predatory practices that watch for patterns in institutional orders do exist. Yet they don't want the government to rein in high-frequency trading because they say it drives innovations in finance and technology in addition to adding liquidity to the markets. Questionable practices such as flash trading that leak information to a subset of traders should be banned, traders agree, but this is just a small part of HFT activity.

No Denying the Need for Derivatives Reform

On the OTC derivatives front, however, buy-side traders welcome increased oversight of dealers. Though transparency into the market is critical to prevent the use of the type of complex derivatives and leverage that led to the blowups of Bear Stearns and Lehman and to untangle the web of counterparty risk that forced the government bailout of AIG, the buy side also wants more competition in derivatives trading, better prices and more visibility into the trading process.

"The movement is away from OTC and toward exchanges and clearinghouses," Stephen Davenport, VP, equity risk management, Wilmington Trust, said at the AT Summit.

Looking beyond the more immediate issues of dark pools and OTC derivatives, the buy side also is concerned about the potential overhaul of the financial markets as a result of regulators' scrutiny of systemic risk in general. Several buy-side executives in attendance at the Summit called for the repeal of the Glass -Steagall Act in order to separate commercial banking from riskier investment banking activities.

There was even a sense of moral outrage on the buy side, a feeling among executives that recklessness (on the part of others, of course) and regulatory negligence have damaged the integrity of U.S. capital markets. "Why are we allowing the system to operate with excessive leverage when we can't effectively allow individuals to renegotiate the terms of their foreclosed homes," exclaimed Davenport.

Even amid all the talk about new regulations, buy-side firms agree that there already were too many rules on the books. In fact, most argue, it was a lack of resources and enforcement that led to the pre-crisis excesses. Nonetheless, as buy-side traders anticipate the new regulatory era, no one wants the pendulum to swing too far in the other direction.