NYSE Euronext and Nasdaq OMX Group – the corporate parents of the America’s biggest stock exchanges – headed to Capitol Hill this week to lobby regulators about a nefarious-sounding phenomenon spreading across Wall Street called “dark pools,” according to Bloomberg News.
There’s certainly no love lost between the New York Stock Exchange and Nasdaq, as these exchanges are bitter rivals competing over an ever-shrinking body of IPOs and order flow. So what are these dark pools, and why are they so threatening as to cause two foes to join forces?
While dark pools sound menacing, they are really just off-exchange forums where traders can buy and sell stock in private – without letting the broader market know what they’re up to. And these frameworks serve a simple purpose: to allow institutional investors who often manage huge portfolios to buy and sell large blocks of stock without causing price movements detrimental to those investors.
For instance, Pension Fund X might want to buy a big block of Exxon Mobil shares. Once word gets out in the market that a big pension fund is buying all these shares of Exxon Mobil, smaller funds will jump in ahead of it, causing the price to skyrocket and the fund to get a bad deal. A dark pool gives the fund a place to anonymously execute the entire order at once, and get the best price possible.
So what are the big exchanges all up in arms about? First of all, these pools are taking away their business. In an environment where trading levels are already down significantly, these dark pools are capturing an increasing amount of the exchanges’ erstwhile business. According to a recent Fox Business report, “as much as 40% of all trading now occurs off the exchanges, a sharp rise from just a few years ago.”
But according to some critics, dark pools are more than just a danger to the big exchanges’ bottom lines. When the SEC announced that it would be investigating the possibility of updating regulations on dark pools, officials indicated that they could harm “price discovery,” the markets’ ability to find the best price for a security. If much of the trading in a specific security is done off exchanges, supply and demand information isn’t being gathered all in one place.
Other concerns include high frequency traders using powerful computer algorithms to game dark pools. According to a report in the The Economist last summer:
“More recently, high-frequency and algorithmic traders have been given access to many broker-dealer owned pools. These can exploit price differences between exchanges and dark pools, for example using speed to lock in a high price, by submitting sell orders to a dark pool, just as the exchange price begins to fall, or buy orders just as a price begins to rise.”
Another concern about the rise of these trading venues, as well as the general proliferation of alternative trading platforms, is market fragmentation. In a letter to regulators obtained by Bloomberg, the big exchanges listed this as one of the main arguments for increased regulation of dark pools. According to the letter, the large exchanges argue that market fragmentation could give rise to events like 2010′s flash crash which showed, “liquidity evaporates quickly when it is spread too thinly across the numerous lit and dark market centers operating in the U.S.”
So will the SEC act to curb the rise of dark pools? It’s been thirteen years since regulations on these alternative trading systems have been updated, so the recent evolution of these markets may warrant some tinkering around the edges. But it is unlikely that the SEC will make sweeping changes, as these systems do serve a real purpose for institutional investors.
Then again, one of the main tenants of financial regulation in the U.S. is the desire for as much transparency as possible, and these dark pools are designed to block out light. As SEC Chairman Mary Shapiro said when the prospect of increased regulation of dark pools was raised in 2009, “We should never underestimate or take for granted the wide spectrum of benefits that come from transparency, which plays a vital role in promoting public confidence in the honesty and integrity of financial markets.”