Regulators Challenge Dark Pool Traders

Stock Exchanges vying to keep their business

A traffic light is seen in front of a Credit Suisse branch on June 11, 2013 in Basel. The Swiss bank was the latest company to decide to cease publishing the volumes of its dark pool stock exchange. (Fabrice Coffrini/AFP/Getty Images)

Dark pool trading is on the agenda of the Financial Industry Regulatory Authority (FINRA), the independent Wall Street regulator. The reason: Independent exchanges operated by banks such as Goldman Sachs have the potential for abuse could harm customers.

Dark pools allow financial operators to perform large-sized stock transactions without revealing one’s identity. 

Market experts suggest the decision by Credit Suisse Group AG to no longer report its dark pool volumes, could have been a trigger for regulators’ renewed interest.

In total, there were 15, and now 14, companies reporting dark pool volumes. There are 12 firms that are silent about their dark pool activities, including Citigroup’s Automated Trading Desk LLC’s Liquidity Ping, Bloomberg Finance L.P.’s Block Hunter, Fidelity Investment’s CrossStream, JPMorgan Chase & Co.’s JPMX, and Merrill Lynch & Co. Inc.’s MLXN. 

FINRA has reason to tackle the dark pool issue because it has oversight over the brokerage industry, which is comprised of 4,250 brokerage firms, according to the FINRA website. 

The present debate centers around publication of dark pool data, which would allow FINRA to provide the public with exact trading information, according to an article on the Tabb Forum website. 

In fact, a June 11 Money Morning article suggests that dark pool operators are not quite truthful with their customers. 

The article states that customers don’t know that the operators analyze incoming and outgoing stock exchange orders and influence prices with large orders. They also know who initiates the trade and the size of orders issued by third parties.

The Money Morning article even suggests that the SEC “can’t let the world know that the markets they are supposed to ensure are fair and orderly are actually a casino rigged by the house, for the house.” 

Regulators Taking Action
Nonetheless, regulators are starting to take action. The SEC charged Boston-based dark pool firm eBX LLC with violating the client confidentiality rule, and the firm, without admitting guilt, paid an $800,000 fine in October of 2012. 

Pipeline Trading Systems LLC, another dark pool operator, was fined $1 million, and two of its executives had to pay $100,000 for keeping its customers in the dark about the fact they were dealing with an affiliate and not the company itself. All those charged paid the fine without admitting guilt, a common practice in SEC settlements. 

Transparency and Reporting Accuracy at Risk
The Credit Suisse decision to halt reporting dark pool volumes “will erase some transparency from the off-exchange market—comprised of dark pools and broker internalizers—where visibility is already quite murky,” an April 23 article on the Advanced Trading website suggests. 

Credit Suisse’s recent move limits the ability of firms, such as the Tabb Group and Rosenblatt Securities, to collect and accurately report dark pool volumes. 

Reporting of trading volumes is valuable because it “[helps] the industry understand how the behavior of market participants changes during periods of extreme volatility and low liquidity ... It is a darn shame that the industry will now lose an important component of that measure,” the Advanced Trading article states. 

Motives for Concealing Data
There are, however, some valid reasons for firms to stop publishing volume data. It would provide the competition with too much information on the dark pool firms’ processes and could profile the firms’ clients, an April 19 Tabb Forum article suggests. 

Competitive forces affect one’s actions. In the case of dark pools, “large investors … would be wary of real-time reporting that could reveal their activity to other traders,” Adam Sussman, partner at the Tabb Group, said in a Tabb Forum article in May. 

In addition, how dark pool volume is collected might distort the final numbers and some see it as an internal company matter and trade secret not to be divulged outside the firm. 

Exchanges Lobbying for More Market Share
In the meantime, traditional stock exchanges are reacting to the threat dark pools pose to their businesses.

The chief executives of the three largest U.S. exchanges, Duncan Niederauer of the New York Stock Exchange Euronext (NYX), Robert Greifeld of the Nasdaq OMX Group (NDAQ), and Joe Ratterman of Bats Global Markets Inc. (BATS), joined forces in an effort to improve the competitive environment and restrict dark pool operators. 

Lobbying is underway by these CEOs to have the SEC put into place a rule that would change the existing pricing system dark pool operators use to charge their customers. 

The exchanges claim that the competitive environment is broken and that they are losing out on fees for “matching up trades and selling price information to brokers.” 

Market experts suggest that the exchanges have lost customers and their trading volumes are down, thus a certain competitive edge has been lost. The exchange CEO’s are mostly interested in having more business return to the exchanges and improving their profits.

A June 3 Bloomberg article references former SEC chief economist Larry Harris as saying that “the exchanges haven’t made the case that today’s volume of dark trading is hurting the quality of public markets.” 

Proponents and opponents of dark pools are confronting each other, with one wanting a piece of the pie and the other not ready to let go. The final outcome of this competitive tussle, however, depends on a resolution of the regulators.