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11:57 AM
Adam Sussman, Director of Research, TABB Group
Adam Sussman, Director of Research, TABB Group
Commentary
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Demonizing the Dark

Adam Sussman, TABB Group’s director of research, comments on the SEC and dark pools, specific to today’s SEC open meeting in Washington, DC beginning at 10:00 am ET to consider whether to propose regulatory changes regarding dark pools.

“There is no evidence that dark pool volume should be curtailed … yet. Although the percentage of matched share volume occurring in the dark has risen steadily during the past four years – from 1.5% in 2005 to nearly 10% today – the absence of data makes it difficult to analyze the affect dark trading has on their own trading, let alone the efficiency of the US equity markets.

Unfortunately, a spate of rumors have circulated within the past 24 hours regarding an SEC plan to reduce the percentage volume of a security that can be executed in a dark pool. That limit is currently at 5%. If the dark pool exceeds that limit, it has to begin publishing quotes in that stock to the national best bid or offer (NBBO), hence, it would no longer be dark. According to one report, this proposed new limit would be between 1% and .25%. The problem is that no one has a clue if any limit is desirable for market efficiency.

There are a number of practical problems in implementing a dark pool volume limit. In a speech on October 8, 2009, SEC Chairman Mary Shapiro recognized the issue of market fragmentation. But if the SEC implemented a .25% limit for each dark pool, dark pool operators would not necessarily route excess flow to an exchange but to another dark pool. In fact, there is nothing stopping dark pool operators from running multiple dark pools (though this might be viewed as an egregious attempt to circumvent the rule). Either way, the dispersion of dark liquidity across more pools would exacerbate fragmentation.

Another issue, one more open to empirical evidence, is that dark trading encourages institutional investors to move orders off their blotter and into a dark matching engine. The result would carry a three-fold effect: they are better able to simultaneously minimize market impact and opportunity cost; arbitrary limits on dark pool volumes could have the effect of pulling liquidity out of the market; and effective spreads could widen significantly, not to mention opportunity costs, as the markets move but traders don’t trade.

While reports of dark pool curtailment could be no more likely than a Tobin-tax, it is critical that this issue, and others on the horizon, be approached in a holistic fashion.

To date, the industry and its regulators have been reactive. Short selling, flash trading, dark pools, sponsored access, liquidity rebates, indications-of-interest (IOIs) – all are being addressed as discrete problems. However, they are all critical support beams of our market structure. As we attempt to strengthen one beam, it is very likely we will damage another and create a less stable structure.

In fact, there is a very inconsistent use of logic in some of these arguments. For instance, when a certain regulatory action such as short selling is deemed bad, observers crow about how the US equity markets were a beacon of efficiency during the Panic of ’08. But then when the spotlight focuses on flash trading, there are cracks in the façade. This isn’t to say we ought to accept the status quo but that the rhetoric (whether advocating for change or not) needs to be ratcheted down.

It is easy to blame the SEC for being short-sighted and reactionary on these issues. They are running for cover while trying to build a better army. The real culprits are in the henhouse. In nearly naked attempts to further their own interest, prominent corporations and their leaders are demonizing certain trading practices and/or order matching mechanisms without any evidence. While these attacks may lead to near-term wins for their business, the overall effect is to degrade investor confidence in our markets and strip the SEC of any chance to allow for self-regulation.

Rather than make blanket statements about the good or evil of a particular business model, industry leaders should provide the necessary data to allow academics and industry participants to understand how these issues fit together so we can make informed decisions about how to improve the overall market. While this may sound vaguely anti-capitalistic to some (why should a company do anything but use its full economic and political power to win?), it will take a good bit of cooperation to keep the US equity markets as the standard-bearer of efficiency.

On that note, the recent announcement by NYSE Euronext to allow dark pools to report trades to the FINRA/NYSE Trade Reporting Facility (TRF) is an excellent step forward. It also appears that many of the same dark pools that currently report monthly numbers to TABB Group and Rosenblatt Securities are likely to participate in this facility.

Participation by these dark pools would improve the ability to measure the effects of dark trading, and provide Wall Street with a clearer picture regarding where, if any, regulation is necessary.”

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