October 17, 2009 / 10:39 PM / 10 years ago

Industry warns on "dark pool" reform

SCOTTSDALE, Arizona (Reuters) - Sweeping rule changes meant to shed light on so-called dark pools, where stock-trading is done anonymously, could ultimately hurt the traditional investors that regulators are trying to empower, trading executives warned over the past few days.

The U.S. Securities and Exchange Commission meets in the coming week to consider changes that the industry widely expects will bring some order to the way dark pools communicate, force them to display more quotes, and publicly reveal more data about the amount of trading taking place outside the formal exchanges.

Executives at a conference said political pressure had a hand in pushing new regulations. They argued that although some changes may be needed, a lack of understanding the way orders circulate among the more than 40 U.S. trading venues could lead to poorer prices and executions for mutual funds, pension funds, and individual retail investors.

“Does the public understand that (new rules are) actually going to have real negative consequences to larger orders that are generally made up of a lot of small retail interest?” Shane Swanson, head of transactions at Citigroup Inc’s (C.N) Lava unit, told the Security Traders Association conference.

Dark pools, private venues primarily used to match large trades, have proliferated this decade as institutions sought safe places to buy and sell “blocks” of stock. They now account for an estimated 10 to 15 percent of U.S. equity volumes.

The SEC, having last month proposed a ban on so-called flash orders, has now turned to dark pools as it cracks down on an increasingly opaque and complex marketplace that some say favors the most sophisticated players at the expense of others.

Commissioners, who meet in Washington on Wednesday, are expected to require from dark pools real-time post-trade transparency so that the public has a better idea where trading actually takes place.

Brett Redfearn, global head of liquidity at JPMorgan Securities (JPM.N), said new data would matter little to the public but would be a boon for high-frequency trading shops — the market’s fastest players that use lightning-fast algorithms to seek out market imbalances, and who could take advantage of the dark pool information.

Swanson added: “That will result in worse impact for those orders. And quite honestly, the small retail orders that are going into the market today already interact with these dark pools. That’s the point that seems to be missed.”

Similar objections were raised over a likely SEC proposal to lower the threshold at which dark pools must publicly display quotes and allow fair access to 1 or 2 percent of market share in a particular stock from 5 percent.


The SEC is also expected to decide that most so-called actionable indications of interest, or IOIs, should be treated as regular quotes and added to the public quote stream.

Dark pools, exchanges, and other market players send or receive IOIs to sniff out trading interest elsewhere. They vary, but can include the stock symbol, order size, and the price, much like a public quote, raising concerns over a two-tiered market favoring those in the know.

“Depending on how you define IOIs, you may find that many dark pools are not so dark. And that is a little bit scary for institutional orders,” Jeromee Johnson, vice president at BATS Exchange, said in an interview. “If they can’t execute in a dark pool, where do they go?”

Len Amoruso, senior managing director at Knight Capital Markets Group NITE.O, told the conference: “There could be a host of very legitimate, very bona fide reasons people are using those IOIs to help execute their underlying orders.”

Redefining IOIs will not simply bring them to the quote stream, Amoruso said, but rather drive them elsewhere or eliminate them altogether.

Taken together, the new rules are expected to slightly curb dark pool, and perhaps kill off smaller ones, according to trading and exchange executives at the STA annual meeting.

While possible rule changes ahead dominated talks, many of those gathered said they were annoyed that, inexplicably, the exchange-traded cash markets were under such scrutiny when the seeds of the financial crisis were sown in the over-the-counter private markets for such products as credit default swaps.

The SEC is under pressure from lawmakers and others to make changes. Alluding to the OTC market crisis, Senator Ted Kaufman said in a newspaper commentary on Friday: “We must also urgently examine opaque and complex financial practices in other markets, including equities, before new problems arise.”

Regulators and politicians are not the only ones concerned. The increased scrutiny has many buyside institutions paying closer attention to who they are trading with, and where.

“If you look at dark pools, from the client side there is a general view that they are getting gamed ... that their order flow is being viewed and traded against,” Dan Renouard, managing director of Robert W. Baird & Co’s institutional equity services, said of long-only clients in an interview.

“That belief has strengthened over the last year,” he said.

Reporting by Jonathan Spicer

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