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Commentary: With Dark Pool Regulation, Be Careful What You Wish For
Traders Magazine Online News, November 16, 2009
On Oct. 21, the SEC voted unanimously to propose regulations that would increase the transparency of dark pools. The proposed rules have not been released yet by the SEC, but public announcements and congressional testimony by SEC staffers have provided a thumbnail sketch.
At the outset, and in the interest of transparency, I hereby disclose that I have no love for dark pools. Nonetheless, from what we can discern so far, the proposed regulation takes aim at the culprit and shoots an innocent bystander.
Dark pools are electronic communications networks--or ECNs--that enable participants to quote and trade equities without displaying their quotes to the public markets. The first dark pool that I can recall was the ill-fated Optimark system that emerged in the late-1990s. Optimark was well-financed and enthusiastically received. It also was a commercial failure.
All that changed with Regulation NMS, a rule change that was intended to foster efficient price discovery by increasing transparency in the listed markets. Once Reg NMS went into effect, dark pools emerged like bats swarming from their caves at twilight. And they were instantly profitable. There are now 40 or so dark pools, and in contrast to other parts of the trading industry in these tough times, they are generally doing well. On a related note, Reg NMS and dark pools also provided abundant profitable opportunities for high-frequency algorithmic trading, including flash orders, but that is a topic for another day.
Reg NMS made dark pools profitable because of its trade-through rule, which requires the execution of better-priced orders before inferior-priced orders can be executed. This part of the rule was intended to encourage institutions to submit large orders into the public markets by preventing other market participants from "trading around" them. Instead, it has had the opposite effect.
The rule raised the transaction costs of executing large orders in the public markets, because it requires smaller, better-priced orders to be executed before a large order at an inferior price can be executed as a block. However, the trade-through rule only applies to orders that are part of the public quote stream. Dark pools could execute transactions among their participants without interacting with the public markets. Reg NMS therefore transformed an unsuccessful business model into an instant success.
The "astonishing" success of dark pools is explained by a very simple principle: Institutional investors do not like to show their trading interest to the public. They dislike revealing their trading interest so much that they are willing to pay extra money to avoid the public markets. This may seem odd, since institutions need to get their trades done, just like all other market participants.
The best explanation for the antipathy of institutional investors to the public markets was expressed by Bernie Madoff, back in the day when he was known for founding and managing a successful and legitimate trading operation, rather than for his criminal expertise running Ponzi schemes. Bernie used to say that he made a career from handling small orders of less than 5,000 shares. Small orders, according to Bernie, contained no information. Large orders, on the other hand, were not simple trades. Instead, they conveyed information, and Bernie's business originally was not set up to deal with that information. Later, he relied on this concept to market something called "order slicing," which was intended to shred larger orders into small, anonymous pieces.
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