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LONDON (Reuters) - The regulatory noose is tightening around dark pools, private share-trading venues that promise anonymity for specialist investors, offering a chance for rival exchanges in the United States and Europe to take back market share.
But traditional stock-exchange operators such as LSE Group, NASDAQ-OMX and Euronext can't just expect business to drop back into their laps after years of seeing market share slip away to more opaque platforms that offer privacy or to upstart venues with slick technology.
A recent batch of enforcement actions against dark pools run by big global banks, coupled with incoming rules in Europe that aim to make markets more transparent by putting a cap on dark-pool trading, has alerted investors to the risks of trading in the murkier areas of the market.
The risks range from concern over a lack of disclosure about how the pools operate and price trades to fears that some give an unseen advantage to high-speed traders using sophisticated technology and computer algorithms.
But in a tough environment where overall trading volumes have yet to return to pre-crisis peaks, it will be no mean feat to persuade professional investors drawn to the lower costs and price stability of dark pools to change their habits and concentrate more trades on a smaller number of venues.
"It is going to be a fight for the public exchanges," said Matthew Coupe, director of regulation and market structure for financial-compliance company NICE Actimize. "The dark pools are not going to give up market share easily."
When contacted by Reuters, several exchanges highlighted the growing momentum behind increased market transparency and said they would work closely with regulators.
"Clearly dark pools are increasingly on the radar of regulators," said Spanish exchange BME. "Operators of regulated market platforms (are) well positioned to take advantage of these changes and turn them into opportunities."
Competition in the exchange business has over the past decade been promoted by regulators as a way to lower trading costs for investors, whose market bets are now fed to multiple venues.
The proliferation of dark pools, which today account for around 12 percent of U.S. trading volumes and 10 percent of Europe's, according to consultancy GreySpark, help match buyers and sellers of big blocks of shares who might otherwise have triggered big price swings on a traditional "lit" stock market.
The excesses of this fragmented system became apparent in the wake of the financial crisis, when the combination of depressed market activity and investment in high-speed electronic trading opened the door to a sophisticated breed of tech-savvy investors able to exploit venues' inefficiencies.
Market watchdogs are now flexing their muscles; Europe's incoming package of proposed rules, known as "Mifid II", is due to be implemented by 2017 under regulator ESMA and aims to cap the amount of dark-pool trading in any given stock at 4 percent per venue and 8 percent across all venues.
"The overarching aim is indeed to move the majority of trading more into the light," a spokesman for ESMA said.
In the United States, which has seen even more fragmentation than Europe, regulators have popular bank-run dark pools in their sights. The New York Attorney General recently filed a lawsuit against U.K. bank Barclays' pool LX, alleging it lied to investors by giving high-speed traders unfair advantages.
Barclays is fighting the lawsuit.
Rival Goldman Sachs was also fined earlier this month by Wall Street's self-funded regulator over pricing rule violations stemming from its dark pool.
"The regulators at first were very keen for fragmentation to increase competition and bring down the cost of trading, but now we have seen the dark side of fragmentation as well," said Peter Lenardos, analyst at RBC. "It's hard not to see how volumes don't to some extent reconsolidate onto exchanges."
Even for large exchanges that have diverse revenue streams, a 3 or 4 percent increase in volume would bring in greater trading fees and potentially grow market data revenue, according to Keefe, Bruyette & Woods analyst Niamh Alexander.
It will, however, take effort to put the fragmentation genie back into the bottle and for exchanges to capture more volume.
Big asset managers remain the most mindful of the risks of shutting off avenues for big block trading, with one trader warning that it would hike costs, even as he acknowledged that investors needed to do more due diligence on trading venues.
UK fund-management body IMA highlighted the positive reasons for dark pools' existence, saying: "Investors choose these pools as they are able to get more stable prices for their clients by interacting with other long-term focused investors."
Skeptics caution that the time alone needed to get Mifid II finalised and up and running – the consultation process is only just underway - might diminish its impact and give time to existing venues to adapt to additional proposed oversight.
And even taking into account the shifting regulatory sands in the United States, few believe the dark pools will be fully drained.
"What I think is that these dark pools may gravitate away from investment banks," said Edmund Shing, portfolio manager at BCS Asset Management. "It may be big asset managers that ask: 'Why don't we just set up our own trading system ourselves?'"
Reporting by Lionel Laurent and Clare Hutchison; Editing by Will Waterman