Dark Pools and Regulations: Is there a need for regulation in dark pool trading?

I am excited to bring you guest posts from industry experts who are knowledgeable, and also generous with their smarts…and their time. We’ll kick it off with Peter Cocuzza who will be contributing once a month on a subject that’s important to the industry. I encourage your comments and feedback – use the comment box below! – Kelly Hushin, TradeTech Blog Editor

By Peter Cocuzza

(Special to The TradeTech Blog)

As a former senior equity trader at a large asset management firm, I enjoyed many years of trading in “traditional execution styles,” executing my order-trade flow through broker-dealers’ traders and sales traders. The “traditional” trading was primarily to execute orders on listed exchanges, through over-the-counter (OTC) dealers and off- board third market dealers through crossing blocks.

These days, much has changed. Orders can now be routed through many electronic venues for quicker and cheaper executions. Just a few years back, it was pretty simple to figure out through where your order was executed since there where only a handful of dark pools. Today there are many (around 40) dark pool networks, and the number is increasing monthly.

This increasingly complex network where trades are made is causing people to questions how and if it should be regulated. From a buy side trader’s point of view, I know the following about dark pools for executing orders is true:

1. We want and need to be represented with our order flow in dark pools as it has become a great source of liquidity.
2. The need for total anonymity is crucial. Institutional investors do not like to show their trading interest for fear of information leakage to the public/street, or front-running, trade-ahead “day traders” as well as HFT traders.
3. Dark pools can provide a cheaper and quicker way to execute large amounts of order-flow for “best execution.”
4. They give the buy side trader total control of the decision and direction of trade order.

Finally, buy side traders/firms want to know where their order is being executed, i.e. which dark pool venue, but – and this is where the debate comes in – isn’t that contra to being anonymous?

Dark pools have provided an alternative execution venue for institutional investors, and for those who would like to pay less to execute other trades as a way to moderate trading costs.

Perhaps the SEC is hoping institutions will continue to shred their orders and send orders up to $200,000 to ECNs, so that the investing public will be able to interact with these orders, allowing the markets to achieve more efficient price discovery.

To this point, the International Organization of Securities Commissions’ (IOSCO) influential technical committee recently published a paper that directs its members to consider reining in the practices of dark pools. While acknowledging the benefits of dark pools, the committee identifies a number of potential problems that it believes regulators should address.

The Madrid-based body’s biggest concern is over transparency. The relative lack of both pre-trade and post-trade transparency, when compared with that of public exchanges, could damage the price discovery process as well as hamper the search for liquidity, IOSCO wrote.

Heretofore, IOSCO has largely confined its work to the regulation of public exchanges. With the publication of this paper, however, it considers extending the transparency requirements of exchanges to dark pools. (In the U.S. dark pools are operated by broker-dealers.)

IOSCO is concerned that because dark pools (and exchanges’ dark orders) do not publish their quotes, they do not contribute to pre-trade price discovery. That raises the issue of “whether they free-ride on the revealed intentions of other participants in the market,” IOSCO wrote.

IOSCO also noted the lack of quote information means that unless a liquidity seeker has the ability to send indications of interest, the only way to find contra interest is to route an order to a dark pool. This could cause a “possible impact on market efficiency with participants having to ping multiple dark pools,” IOSCO stated.

IOSCO’s paper had a laundry list of recommendations for regulators. For one, it suggests they should consider whether or not so-called “actionable IOIs” should be deemed quotations, and therefore displayed. Second, IOSCO recommends that regulators consider whether or not the identity of the dark pool should be revealed once the trade is consummated. The organization states that regulators should decide whether the dark pools should be identified on a real-time basis or an end-of-day basis and whether dark pools should be identified on a trade-by-trade basis or in the aggregate.

Surely the debate and different views and opinions on dark pools will continue until proposals from the SEC, IOSCO and whoever else, ever take effect. Even then, I am sure that there will always be some who root for regulation and some who don’t.

Peter Cocuzza is a global equities and derivatives trader who has spent time at OppenheimerFunds and PaineWebber Inc.

Related posts:

1. Larry Tabb, Tabb Group, on the Flash Crash, Asian markets and where US regulation is heading