The question is constantly out there: Will the SEC place new regulations on nondisplayed pools of liquidity, otherwise known as dark books? That was the topic of discussion at a Liquidnet press breakfast in mid-April featuring Seth Merrin, Liquidnet's founder, and former SEC chairman Harvey Pitt, who now is a consultant with Kalorama Partners in Washington, D.C.
Pitt, who was at the SEC's helm from 2001 to 2003, says he believes the Commission is taking the right approach to dark pools. "They are talking about the issue and looking at the issue -- they are not acting on this issue yet," he observes.
The issue, he explains, is the growing number of dark pools and the market fragmentation they are causing. The number of nondisplayed liquidity pools a year ago was about four; according to reports, there are as many as 40 today. The problem, Pitt says, is that "fragmentation can produce disproportionately bad pricing."
Many of the newest dark pools are being created by broker-dealers to connect and automate the execution of internal order flow coming from once-siloed areas, such as retail, proprietary and institutional desks. These broker-run alternative trading systems (ATSs) are dark in that they cross orders anonymously and do not quote out to the market.
This also may concern the SEC because an intermediary (the broker) is representing both sides of the order, Pitt notes. But both Pitt and Merrin point out that internalization of orders has always been conducted by phone; the only difference is that now it is being done electronically.
Despite these two areas of concern, Pitt suggests that the SEC take a wait-and-see approach. "They need to understand what's going on and figure out if there is a problem with lack of transparency and, if there is, when does it arrive?" he states.
Pitt adds that he believes the SEC may be entering a period of change with Erik Sirri in the position of director of market regulation. "Erik is not a lawyer, he's an economist, and he thinks differently from the way a lawyer would think," Pitt says. "He may come at this with a new and different approach from past Commissions."
Pitt's most important piece of advice to the SEC is to use economist judgment and define how the Commission wants the market to function, then set principles and standards to further that model."
Pitt suggests that past regulation, including Regulation National Market System, has not always benefited the market. The best-execution requirements under Reg NMS equate best execution with best price, but he argues that best price does not always mean best execution. "It may be for the guy trading a 100-share order," Pitt says. "But if there is a 100,000-share order, that person's best execution may be to get the entire trade done as quickly as possible or to execute it anonymously at the midpoint," he adds.
"The buyers and sellers need to determine what is best for them, not the regulators, and certainly not a 573-page rule," Pitt exclaims.
But is the growth of dark pools a bad thing? They may have a controversial name, and fragmentation could be a problem, but Merrin points out that trading in these pools of liquidity often results in better execution than trading on the open market, especially when trading large block orders. He also believes there will be consolidation among dark pools, which will alleviate the market fragmentation issue.
The market share in these dark pools keeps climbing, so the SEC will probably continue to watch closely. Aite Group estimates the market share of NYSE listed stocks in dark pools at 17 percent. Merrin says he could see that number climbing to 25 percent by the end of the year. Aite Group estimates overall market share of dark pools (combining both NYSE and Nasdaq stocks traded on these venues) at 10 percent.