What's the Matter with Dark Pools?
Speakers Sound off at Traders Magazine Live Panel
Traders Magazine Online News, October 2, 2009
Dark pools are on the regulatory front burner. They're seen as competing with the displayed markets, even as they've captured a segment of trading from the desks of broker-dealers' upstairs.
The Securities and Exchange Commission is now bearing down on issues related to trading in dark pools and how much flow can execute in individual pools without triggering obligations to the rest of the marketplace. To provide some perspective on this broader discussion, a panel at last week's Traders Magazine Live conference addressed the core issue of what role is served by broker-operated dark pools that, by and large, do not print block trades.
The conference, which took place at the Down Town Association in New York on Sept. 24, drew a standing-room-only crowd of almost 200 trading executives. Robert L.D. Colby, counsel at law firm Davis Polk & Wardwell, in Washington, D.C., moderated the panel on dark pools. He is a former deputy director of the SEC's Division in Trading and Markets.
Colby noted that the SEC has traditionally had a "binary view" of dark and lit liquidity, since the lines between them were much clearer. As the structure of the markets has evolved, dark and lit markets began to overlap. Now, Colby said, many venues are "semi-dark" or "semi-lit"--a shift that raises more complex issues for regulators.
Dark pools and exchanges now interact. Many dark pools route orders to one another, exposing flow to other alternative trading systems in the hunt for liquidity. NYSE Arca, Nasdaq, BATS Exchange and Direct Edge have programs enabling dark pools to stream quotes to them, so they can avoid routing orders to other markets if they can't fill orders.
Pools such as Credit Suisse's CrossFinder, Goldman Sachs' Sigma, LeveL ATS and others also have average execution sizes of several hundred shares, not much more than the average execution size on exchanges. Liquidnet, in contrast, has an average execution size of over 49,000 shares.
For the SEC, this raises questions about whether the functions of these venues have changed in recent years. SEC Chairman Mary Schapiro said a week ago she was concerned that "the public markets may be deprived of the valuable trading information, including price discovery, available in dark pools." She mad that comment in a speech at the Financial Services Roundtable's conference on Sept. 24.
Brian Hyndman, senior vice president for transaction services at Nasdaq OMX Group, noted at the Traders Magazine conference that dark pools play a role in the trading industry but that they clearly take information away from the displayed markets. He stressed that Nasdaq isn't against internalization. "For the record," he said, "internalization and dark pools are good." But he went on to point out that "maybe price formation in the public markets could suffer" if enough liquidity doesn't get to the public markets.
Exchanges, it should be said, also have their own dark orders types amidst their displayed market. At Nasdaq, for instance, about 16 percent of executed volume involves a party that was non-displayed. The percentage of volume at BATS that involves at least one dark order is a few percentage points lower.
The brokers on the Traders Magazine panel made a case for off-board trades. Owain Self, head of algorithmic trading for the U.S. and Europe at UBS, noted that blocks have historically traded upstairs and that they "were never done in the displayed market." Many of those big orders, he said, now execute algorithmically in dark pools, where they can seek to avoid the information leakage they might encounter in the displayed markets.
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