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Bringing Clarity to Dark Pools

Mar 06. 2015

Up until June 2014, when New York State’s top securities regulator sued Barclays for favoring high-frequency traders over other investors in its dark pool, this sinister-sounding term was not nearly as well- recognized as it is today. Even now, “dark pool” carries an aura of mystery, and there are many misconceptions about its definition and operations.

It is worth mentioning at the outset that dark pools have been around since trading began, albeit under other names, such as “upstairs trading.” The term is simply Wall Street slang for private stock trading platforms operated primarily by brokerages. In the present context, dark pools are electronic alternative trading systems, very similar to stock exchanges, where trades can be matched. The orders are “dark” because the size and price of trades are not revealed to other participants in order to limit the amount of interaction and minimize price movements. These pools are mostly used by sophisticated professional traders.

Another common misconception – rising out of comments in the media implying that a dark pool is somewhat of a black market – is that it is a place where anything goes, and customers are exploited by profiteering brokers. However, in reality, dark pools are highly regulated. All dark pools are broker-dealers registered with the SEC and with the Financial Industry Regulatory Authority (FINRA), and they’re subject to regular audits and examinations, similar to an exchange. Dark pool trades are further bound by the "NBBO," or National Best Bid and Offer, which means that prices cannot be chosen arbitrarily. While dark pool prices are frequently the midpoint of the NBBO, dark pools are not permitted to trade at prices beyond the NBBO without an intermarket sweep that satisfies orders on other markets.

Non-exchange trades have grown to about 40% of all US stock trades in 2014, which is up from 16% six years ago. Dark pools have been at the forefront of this trend, accounting for about 15% of the US volume, which serves as evidence that institutions find it to their advantage to engage in dark pool trading. This picture is similar in the UK and throughout Europe, as technological advancements have lowered costs, allowing broker dealers to route more of their order flow to their own private pools first, before sending the leftover orders to the exchanges.

Exchanges have taken notice and reacted to these trends. In 2013, chief executives of NYSE Euronext, Nasdaq OMX and BATS Global Markets argued for regulators to introduce rules imposing certain restrictions on transactions taken away from public exchanges, pointing out similar steps taken by other regulators around the globe against the rise of off-exchange trading or dark pools.

The Wall Street Journal recently reported that the Nasdaq OMX Group has approached several big banks with a proposal to take over the operation of their so called "dark pools," and further plans to seek regulatory permission to do so, according to Nasdaq Chief Executive Robert Greifeld.

If you can’t beat ‘em, join ‘em!

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