Dark books, dark pools, undisplayed liquidity -- whatever name it's given, not since chlorofluorocarbons were identified as a main source of ozone depletion has something invisible gotten so much media attention. Now it seems that regulators are preparing to increase scrutiny on electronic trading that takes place outside the traditional exchange structure. With a new entrant every few months, the number of nondisplayed trading venues, variously estimated at 30 to 40, keeps growing.
In a January 2007 report, the TABB Group estimates that the number of shares per day traded in crossing networks and broker-operated internal markets will increase 43 percent per year, from 512 million in 2007 to 1.48 billion in 2010. TABB Group analyst Jeromee Johnson estimates that the overall U.S. equities market is currently 9.4 percent "dark," and that may increase to 15 percent by 2010.
The numbers have gotten the SEC's attention. On Sept. 12, 2006, Erik Sirri took the helm of the SEC's Division of Market Regulation. Within days he told the Investment Company Institute that the SEC needs to "better understand" these pools and that the presence of these dark venues "brings up serious policy considerations and transparency issues," according to media reports.
For this article, Sirri issued the following statement: "One of the Commission's goals is to promote vigorous competition among markets. In addition to the exchange markets, however, other types of trading platforms have sought to compete for a share of U.S. equity trading. These include crossing systems that facilitate block trading by institutional investors as well as liquidity pools operated by broker-dealers that seek to cross orders internally without any interaction with the transparent, public markets. ... The number of broker-dealers operating these 'dark' pools of liquidity has grown rapidly.
"They can benefit their participants by minimizing the impact of trades on quoted prices and avoiding the trading fees charged by public markets. On the other hand, they increase the fragmentation of trading volume in U.S. equities and may detract from efficient public price discovery. The extent to which these nontransparent and restricted-access trading alternatives are able to divert significant trading volume away from the public exchanges will be an important market structure issue for the Commission and Division staff to monitor."
There already are regulations on the books to govern dark pools. "When Reg NMS came in, it modified some provisions in Reg ATS, specifically market-access rules," says TABB Group's Johnson. "It lowered a key threshold from 20 percent market share to 5 percent market share in a given name over a 60-day period -- if you exceed that threshold, you need to display a quote through an SRO [self regulatory organization] or be an SRO to the public market. If anonymity is your model, that shoots your model in the head."
After receiving a petition from Liquidnet, the SEC made an exception to this rule for the dark-book operator because Liquidnet's closed-network model is essential to its value proposition. The exemption relates specifically to the portion of the regulation that stipulates that fair and open access to dark books is to be provided, even if they are under the 5 percent threshold. Liquidnet's stock-in-trade is that it prohibits broker participation in its main market, and its popularity with the buy side is largely due to its peer-to-peer model.
But the decision may not be sitting well with the SEC after all, according to Johnson. "What I hear from the SEC is that they regret making the exception," he contends. "And now that dark books are popping up left and right, it is more likely that Liquidnet would lose its exemption than another venue would be granted an exemption."
Even if regulators took a stricter view of Liquidnet's activities, it exceeds the 5 percent threshold on only a very few occasions, Johnson notes. And it could always go "pitch dark" -- offer securities for trade but remove the prices from all screen displays in a scorched-earth interpretation of "fair access" for a few days until volume went down, he explains.