December 28, 2009

Dark pools have carried an ominous connotation since the term was first coined about five years ago. But despite the unfortunate moniker, dark liquidity pools -- which actually have been around since the late 1980s -- serve a highly useful purpose for buy-side traders looking to trade large blocks of stock with minimal market impact.

While the dark pool frenzy peaked in the past few years, the controversy surrounding the anonymous venues had seemed to quiet down some as they took their place in today's financial landscape as an efficient alternative to trading on public exchanges and lit venues. Now, however, following the financial meltdown of the past year and a half and the resulting political scrutiny on the markets, dark pools have reemerged as a target for the Securities and Exchange Commission and potential regulatory reform.

According to the SEC's Fact Sheet About Dark Pools, the number of active dark pools has increased from about 10 in 2002 to about 29 in 2009. In the second quarter of 2009, the SEC reports, the combined trading volume in dark pools represented about 7.2 percent of overall market volume; no single dark pool executed more than 1.3 percent of share volume. The SEC says this growth in the dark pools has resulted in a lack of transparency that "could create a two-tiered market that deprives the public of information about stock prices and liquidity."

Nonetheless, the SEC does recognize the value of dark pools. "Collectively, darkness is harming the markets, but individually dark pools are helpful," said James Brigagliano, the SEC's co-acting director of the division of trading and markets, during testimony before a Senate subcommittee hearing on market structure issues in late October.

The Commission has introduced three main proposals to address the complex issue of dark pools. As the SEC moves forward with its comment period on the proposed new rules, the dark pool operators as well as buy-side and sell-side traders all have opinions and concerns.

The Proposals

The first proposal under discussion would treat actionable indications of interest (IOIs) as quotes and subject them to the same disclosure rules. According to the SEC proposal, "Dark pools transmit this information only to selected market participants. In this regard, actionable IOIs can create a two-tiered level of access to information about the best prices and sizes for NMS [national market system] stocks that undermines the Exchange Act objectives for a national market system."

The SEC also is proposing to lower the ATS trading volume threshold for displaying best-priced orders. Currently, if an ATS -- including a dark pool that use actionable IOIs -- displays orders to more than one person, it must display its best-priced orders to the public when trading volume on the venue for a stock reaches 5 percent of total volume in that stock. The commission has said it would lower this threshold to 0.25 percent.

Both of these proposals would exempt IOIs related to large orders -- specifically, IOIs for $200,000 or more or that are communicated only to those who are "reasonably believed to represent current contra-side trading interest of equally large size."

The third proposal would require real-time disclosure via public reports of executed trades on dark pools and other ATSs. Again, the requirement would have an exemption for trades of $200,000 or more.

Given the disruptive nature of the proposals, the SEC seems to have made a strong effort to gauge market participants' reaction to the changes. "The process the SEC went through this time in speaking with the sell side, the buy side, dark pool providers and exchanges demonstrated a more comprehensive evaluation of the issue," according to Laurie Berke, principal at financial market advisory and research firm TABB Group.

Fred Federspiel, president of Pipeline Trading Systems, suggests that the SEC has taken a careful approach to introducing new requirements. "[It] explicitly recognizes the difference between size discovery trading and price discovery trading," he says. "They have specifically allowed continued innovation on size discovery mechanisms on block trading systems [that] the regulators agree are in the best interest of the institutional trading community."

Noting that while Pipeline does not employ actionable IOIs, it does provide institutions with the option to communicate with large, natural contra-parties, Federspiel adds that the proposed regulations would still enable Pipeline to reach out to "large, natural contra-parties to try to arrange trades anonymously electronically."

Brian Fagen, co-head of liquid market sales for the Americas at Barclays Capital, suggests that the SEC's bark with regard to dark pools is bigger than its bite. "The proposed regulations obviously have potentially far-reaching implications, but its more likely that the ultimate outcome will be much less so," he asserts. "The headline looks really bad -- 'The End of Dark Pools.' But when you reach down inside and see what actually gets done, the reality may be very little change at all."

Fagen continues, "You'll have a hard time saying to someone that dark pools have increased trading costs or dark pools have not enabled institutions -- and through them, retail investors -- to reduce trading costs. They have, and it's easy to prove."

Adds Tim Olsen, SVP and head trader at ICM Asset Management, "I'm concerned the SEC will overregulate." Olsen expects that the SEC will have dark pool rule changes in place by next fall, possibly sooner. "If we step back and think about why dark pools were created, it was largely out of distrust from the buy and sell side to work blocks. To take some of the rules away goes against why the marketplace was created and is a slippery slope for the government."