Commissioners Discuss Dark Pools

By Lisa Valentine

How much truth is there to the criticism levied at dark pools that “every share that is crossed in the dark is a share that doesn’t assist the market in determine an accurate price?”

SEC Commissioners debated the benefits and disadvantages of dark pools last week, batting around the pros and cons of legislation such as including actionable Indications of Interest (IOI) in the consolidated public quote stream and how to apply floor-based trading principles to automated electronic markets.

According to the SEC, the number of active dark pools has increased from 10 in 2002 to approximately 29 today. In the second quarter of 2009, dark pool trading accounted for 7.2% of the volume of these stocks.

At first glance, it would appear that dark pools are sucking market share away from quoting venues and making the entire market less transparent. However, this is not necessarily the case. While trading volumes at NYSE are down, volumes at other quoting venues such as Nasdaq, NYSE Arca, BATS and Direct Edge are increasing, according to SEC Commissioner Kathleen Casey. She says, “It appears that an obsessive focus on the rise of dark ATSs is misplaced.

In the end, the SEC voted to propose amendments to dark pool legislation, but the commissioners were not all in agreement about the viability of these amendments.

The SEC proposal contains the following three recommendations:

1.    Require actionable IOIs to display quotes and be subject to the same disclosure rules that currently govern non-dark pools.
2.    Lower the trading volume threshold of NMS stocks from 5% to .25%. Today, an alternative trading system (ATS) must display its best-priced orders to the public only when its trading volume for a stock is 5% or more.
3.    Require real-time disclosure of the identity of the dark pool executing a trade on the consolidated tape.

To avoid information leakage that could move markets, the SEC is exempting trades worth more than $200,000 from these recommendations.

Several commissioners, notably Casey and Troy Paredes, expressed concern that the SEC is moving too fast to regulate dark pools. (The name could have something to do with the urgency as the term “dark pools” sounds so negative. Dark pools are an easy target in much the same way executive compensation has become a political rallying cry.) Casey summed up her concern well by admitting that the SEC may not really understand dark pools enough to enact sweeping reform. Said Casey, “Sometimes we don’t know what we don’t know, and if we rush to regulate without a complete understanding of the extent to which complex and dynamic activities may be interrelated, the specter of unintended consequences looms large.” Casey called for decision-making to be “driven by data, not politics or unfounded assumptions.”

Paredes said, “I am concerned that considering particular features of dark pools in isolation increases the risk of unintended adverse consequences and will not yield the best results for our markets.” For example, he warns that dark pools may actually become darker as participants choose not to send actionable IOIs at all.

Or, an even more ominous darkness may descend on trading. “The demand for non-displayed liquidity presumably will continue despite any regulatory changes that may be adopted,” Paredes correctly stated. Where will non-displayed liquidity go? Perhaps to foreign markets.

By trying to shed light on dark pools, the SEC may indeed create something worse. Be careful what you wish for.

The SEC is gathering public comment.