Dark Pools Seek Limited Transparency

Dark pools provide institutional investors with a valuable venue for trading large blocks of securities. But new regulations may change the way market participants interact with anonymous trading venues in 2010.

Why It's Important: Dark pools, which are not new to the markets, provide liquidity and help institutional investors trade large blocks of securities anonymously. Asset managers find value in dark pools when they are worried about exposing their large orders that may move the market ahead of their trade. But politicians and regulators who are concerned about investor confidence have focused on dark pools (along with high-frequency trading and flash orders) as they look to restore confidence in the U.S. markets, according to Cheyenne Morgan, analyst with TABB Group. "A lot of this is sparked because the SEC is under a lot of pressure, rightly or wrongly, to restore confidence in the U.S. markets," she says. "Looking at these issues, at the very least, it is a good reason for the different participants in the industry to get together and discuss what is best for the markets." Most participants expect dark pools -- either through regulation or voluntarily reporting -- to increase transparency for investors in 2010.

Where the Industry Is Now: Since dark pools are anonymous and do not report trades "to the tape," as other traditional trading venues are required to do, it is hard to get an accurate estimate of dark pools' influence on the market. "There is a severe lack of information," says Sang Lee, cofounder and managing partner at Aite Group. Even as an independent research and advisory firm, "We can't accurately gauge the market. We estimate the size of the dark pool market [trade volume] at about 12 percent. Brokers think that dark pools hold 20 percent of the market. Some venues over report volume, some under report and some don't report at all."

The opaqueness of the dark pool market is one reason why politicians are looking closely at the way dark liquidity providers operate. During a Senate hearing on "Dark Pools, Flash Orders, High-Frequency Trading and Other Market Structure Issues" on Oct. 28, various market participants discussed the value of dark pools. One theme emerged: More transparency is required. Peter Driscoll, senior trader at Northern Trust and chairman of the Securities Traders Association, said at the hearing he believed that it is important for the SEC to investigate dark pools, and that he was concerned about the ways orders are routed through the opaque venues. "We are sending orders to dark pools, and it is our right to know how they are handled. Transparency in the order-handling process is extremely important."

But too much transparency would hurt many investors -- the market participants the regulations are designed to protect, warned Dan Mathison, managing director of Advanced Execution Services at Credit Suisse, which runs its own dark liquidity network. "Despite the unfortunate name, dark pools are beneficial for investors," he said at the hearing. "Those who would compel dark pools to display orders would be helping short-term-information-based [or high-frequency] traders."

Focus in 2010: Much of the work to regulate dark pools will ned to balance the needs of investors. Regulators will try to determine how much transparency is needed to make sure all investors -- institutional and retail -- are treated fairly, without providing too much transparency that would render the dark pool market useless (by providing too much information to traders who may front-run or "game" the market). "There will be more scrutiny, but anything can happen," says Dave Csiki, managing director at INDATA, a provider of buy-side trade order management (OMS), compliance and portfolio accounting software. "Our clients say that dark pools are valuable and provide liquidity. More oversight might be healthy, as long as it doesn't stifle innovation from the dark pools."

Competitors, such as exchanges and brokers that must display trades, also are lobbying for more transparency as they look to even the playing field or gain a competitive advantage in the hypercompetitive U.S. equity markets. "The displayed pools view the dark pools as a threat, and in this political climate they are an easy target," says Aite's Lee. "It is easy because the concept of a dark pool is opposite of what people talk about when they discuss the open and regulated exchange-traded marketplace."

Even ITG, which runs its own dark pool, POSIT, wants more openness. "We support efforts to improve transparency, as long as it is applied fairly across the markets," CEO Bob Gasser said at the Senate hearing. "Sunshine is the best disinfectant here."

Industry Leaders/Technology Providers: Some of the leading dark pools, according to TABB Group's 2009 LiquidityMatrix, are Crossfinder (Credit Suisse), Knight Link (Knight Capital), SigmaX (Goldman Sachs), Liquidnet, MSPool (Morgan Stanley), Millennium (NYFIX), Getco, LeveL, Barclays and Instinet.

Price Tag: Most brokers help asset managers connect to dark pools. Since connecting to dark pools can help reduce market impact, the cost savings can be significant.

Greg MacSweeney is editorial director of InformationWeek Financial Services, whose brands include Wall Street & Technology, Bank Systems & Technology, Advanced Trading, and Insurance & Technology. View Full Bio