Swimming in the Deep End: A Primer on Dark Pools

uploads/allpics/tyaf4d41u3o284735.jpg“Dark pools of liquidity” have recently become the focus of increased regulatory scrutiny, including a number of high-profile enforcement actions related to these alternative trading systems.   This increased scrutiny follows on the heels of Michael Lewis’s popular book, “Flash Boys,” which introduced the public at large to dark pools through its allegations that high frequency trading firms use dark pools to game the system to the detriment of common investors.   But what exactly are dark pools and do they have any redeeming qualities?  This post provides a primer on the benefits and disadvantages of dark pools and why they matter.

In general, “dark pools of liquidity” are private alternative forums for trading securities that are typically used by large institutional investors and operate outside of traditional “lit” exchanges like NASDAQ and the NYSE.  The key characteristic of dark pools is that, unlike “lit” exchanges, the identity and amount of individual trades are not revealed.  The pools typically do not publicly display quotes or provide prices at which orders will be executed.   Dark pools, and trading in dark pools, have proliferated in recent years due in part to the fragmentation of financial trading venues coupled with advancements in technology, including online trading.  There are currently over 40 dark pools operating in the United States.  Around half of these are owned by large broker-dealers and are operated for the benefit of their clients and for their own proprietary traders.  According to the SEC, the percentage of total trading volume executed in dark venues has increased from approximately 25% in 2009 to approximately 35% today.

As the volume of trading in dark pools has increased, so has the SEC’s focus on dark pools as transparency is a hallmark of the U.S. securities markets.   The SEC has stated that lack of transparency may have a deleterious effect on market efficiency as “the consensus of the research is that the current extent of dark trading can sometimes detract from market quality, including the informational efficiency of prices.”   In addition to a lack of transparency regarding individual trades, the SEC has also expressed concerns regarding the lack of transparency into how dark pools operate.  These concerns are echoed in the recent book, “Flash Boys,” which alleges that high frequency trading firms join dark pools to search for large hidden stock orders, and then use that information to trade on lit exchanges before information regarding the large trades becomes publicly available.

The lack of transparency in dark pools, however, may afford certain advantages as well.  Investors can, for example, trade large blocks of securities without revealing their identity or intentions to the market, which in turn minimizes the market impact of their trades.  SEC Trading and Markets Chief Stephen Luparello, who testified on June 26, 2014 before the House Financial Services subcommittee on Capital Markets and Government Sponsored Enterprises, compared this aspect of dark pools to the example of Disney Corporation purchasing large tracts of swampland in Florida 40 years ago through an anonymous shell corporation at then-market prices.  Had Disney attempted this in a state where prices and beneficial owners behind real estate transactions were immediately made public, speculators would have immediately driven up the price to Disney’s detriment.  Moreover, the existence of multiple trading venues may spur competition and result in reduced fees and increased quality of services.  Indeed, the SEC has stated that competition among multiple trading venues may well benefit investors by encouraging services that meet particular trading needs, by keeping trading fees low and by helping to avoid trading disruptions if one venue has an isolated problem.

Thus, while dark pools have certainly fallen on dark times, the impact of dark pools on the market is far from certain.  As Mr. Luparello noted during his recent testimony, “while dark pools sound bad to the public because of the implication of opacity, forcing every transaction into the open would create [a new set of] winners and losers.”   The SEC has stated that it is studying the impact of dark pools on the market as part of a comprehensive review into whether and how the SEC’s regulatory approach for trading venues should be changed to reflect the current environment.