What lurks for hedge funds beneath the deep, dark waters of dark pools?

Hedge Fund Regulation 05 Nov 2009

really_dark_poolOne could be forgiven for thinking a dark pool was an obscurely-lit body of water.

Of course, a dark pool in the context of trading and execution is, as explained by the Securities and Exchange Commission, “a type of alternative trading system (ATS) that does not display quotations to the public.”   They have grown in popularity over the past few years, particularly for alternative investment managers looking to shop around and get a one-up on price — and the competition.

It is largely due to this lack of transparency and their growing proliferation that the SEC has become increasingly concerned with regulating them in some form.   Just two weeks ago, SEC Chairman Mary Schapiro outlined a fairly comprehensive plan on how exactly the commission is looking to gain more oversight over dark pools.

“Although dark liquidity always has existed in one form or another in the equity markets, the commission must assure that the public markets and non-public trading venues operate within a balanced regulatory framework,” Schapiro said in opening remarks before a commission meeting on dark pools, in which James Brigagliano, co-acting director of the SEC’s trading and markets wing, provided testimony. “This means that as markets evolve, the commission must continually seek to preserve the essential role of the public markets in promoting efficient price discovery and investor confidence.”

Uh oh.

It wasn’t so long ago that the way to execute a trade was to pick up the phone, call a broker and have them shop around for a buyer or group of buyers to get the best possible price. The trick was finding the right broker with the right access to the right markets to get the job done quickly, efficiently and in most cases without having the rest of the market get wind of it.

Clearly those days are gone. As technology has come to rule the trading world, so too has the need for various systems and software that not only can automatically slice and dice a buy or sell order in fractions of a millisecond but in algorithmic perpetuity cull numerous far-flung and competing markets with varying degrees of transparency, liquidity and stealth to find the best matchups at the most competitive pricing.

Hence the emergence of “dark pools.”

Schapiro and the the SEC are basically looking at three proposed changes:

  1. Require actionable “Indications of Interest,” or IOIs, to be treated like other quotes and subject to the same disclosure rules as any other buy or sell quote.
  2. Lower the trading volume threshold applicable to alternative trading systems for displaying best-priced orders to .25% for alternative trading systems, or ATSs, from the current 5% minimum threshold.
  3. Create the same level of post-trade transparency for dark pools – and other ATSs – as for registered exchanges. Specifically, amending existing rules to require real-time disclosure of the identity of the dark pool that executed the trade.

What would that mean for users of dark pools? In essence, they’d become a lot lighter, like 95% lighter – i.e. a lot more transparent than they are now.

Critics of dark pools maintain that they have “created a two-tiered market, in which only some investors in dark pools but not the general public have information about the best available prices,” Sen. Jack Reed, D-R.I., chairman of the Senate Banking Subcommittee on Securities, said last week.

Operators of the pools counter that they indirectly benefit retail investors by providing speed and efficiency for their users — including mutual funds and alternatives managers. According to the SEC, the number of dark pools has grown from 10 in 2002 to 30 as of this year, and counting.

If all of this has a familiar ring to it, it is because almost the same thing occurred a dozen years ago when the SEC deregulated electronic trading.

The move created a flurry of electronic communication networks, or ECNs, which operated not that much differently than today’s dark pools. The first wave of ECNs was followed by decimalization of the US equity markets in the fall of 2000 and later the introduction of the Regulation National Market System, or Reg NMS, in 2005, which prompted a second coming of ECNs.

Good or bad, it seems regulation of dark pools is well on its way. More interesting is what other markets are likely lurking out there to replace them.

Be Sociable, Share!

Leave A Reply

← Can of worms? Supreme Court discusses "fair" compensation for fund advisory services More evidence that distressed debt funds are a phoenix, not a vulture →