This past month, the Financial Industry Regulatory Authority required dark pool traders to publicly report their activities on a security-by-security basis.
The top five dark pool firms control roughly 50 percent of the alternative trading systems. They are: Credit Suisse, Barclays, UBS, Merrill Lynch and Morgan Stanley.
Dark pool trading
involves exchange-listed securities traded on non-public venues by private brokerages. These venues permit anonymous bids and offers to remain unannounced to the general market. The price is publicized after the transaction is executed. They are subject to less regulations and public disclosure requirements than that imposed on public exchanges and have increased market complexity and fragmentation while reducing investor confidence.
Opaque pricing and terms are granted to selective participants. This allows large institutions, such as mutual funds, hedge funds, pension funds and insurance funds, to buy or sell large blocks of shares with minimal price movement. This trading strategy essentially undermines the true pricing of securities. It unfairly maximizes profits — or minimizes losses — for those involved at the expense of other market participants.
Terrence Duffy, chairman of CME Group, suggested to Bloomberg that dark pools should be shut down completely because of their opacity. Futures markets work better than the stock market does due to greater transparency.
Dark pool trading as a percentage of total trading volume more than tripled from 4 percent in early 2008 to nearly 14 percent by the end of 2011, according to Rosenblatt Securities. Together with firms that execute trades on behalf of retail brokerages, dark pools account for nearly 40 percent of all stock trading, according to Tabb Group.
High-frequency trading thrives in this type of opaque environment. High-frequency trading accounts for approximately 48 percent of all U.S. share volume, according to Tabb Group.
Mary Jo White, chairman of the Securities and Exchange Commission (SEC), is developing numerous regulatory proposals that would target high-speed traders, less transparent trading venues and order-routing practices to increase market competition, transparency and stability.
High-speed traders would be required to register with regulators, provide access to their trading activities for inspection and limit aggressive, short-term trading strategies during vulnerable market conditions. Frequent batch auctions are being considered to minimize speed advantages that actually disrupt the market-clearing mechanisms. Affirmative and negative market-making obligations might be instituted to prevent market manipulation, such that liquidity is provided only when required.
Dark pool operators would be forced to provide information about their clients and how they process buy and sell orders in an attempt to prevent illicit money-laundering activities.
In response to complaints that routing decisions sometimes undermine the investor's interests, brokers would be required to inform clients where their trades will be executed. Fees and rebates to brokers from the exchanges would be analyzed to determine if this pricing model reduces liquidity, promotes true price discovery and provides social benefits.
The SEC is also examining whether its Regulation NMS (National Market System) precipitated the increased use of dark pools by requiring the execution of trades based solely on lowest cost, rather than permitting other criteria to be used by market participants.
Recently, the SEC cited Liquidnet and Wedbush for improprieties committed in the dark pool space.
Liquidnet, one of the largest independent dark pool operators, agreed to pay a fine of $2 million for disclosing confidential client information on its private trading platform.
Wedbush, a top five Nasdaq trader, permitted virtually anonymous foreign traders to route billions of dollars of orders directly to U.S. trading venues. Wedbush also failed to prevent illegal transactions, including naked short sales, wash trades, manipulative layering and money laundering.
Naked short sales involve the selling of shares that have not yet been borrowed. A wash trade represents the simultaneous sale and purchase of the same security in equal amounts and executed by different brokers. Manipulative layering is the placing and canceling of orders by high-frequency traders.
High-frequency trading essentially provides liquidity to create trading volatility. They do this by taking the price out of equilibrium and forcing it back. This generates large trading volume, revenue and profit.
Increasing competition and transparency would certainly foster a more stable, less volatile trading environment. As such, financial assets would weather resource dislocations with more aplomb. It would also promote long-term investment that more readily translates to higher levels of employment and income.
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