Dark pools

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Dark pools of liquidity (also dark pools or dark liquidity) are crossing networks that provide liquidity that is not displayed on order books. This is useful for traders who wish to move large numbers of shares without revealing themselves to the open market.

Dark liquidity pools offer institutional investors many of the efficiencies associated with trading on the exchanges' public limit order books but without showing their hands to others. Dark liquidity pools avoid this risk because neither the price nor the identity of the trading company is displayed.

See also High frequency trading and Short sales.


Congressional oversight

Senate hearing on dark pools - Oct 28

The Senate Committee on Banking, Housing & Urban Affairs is holding an extended hearing on Market Structure Issues.

Link to live webcast can be found here.

The full list of panelists and presenters:

  • Honorable Edward Kaufman, United States Senator
  • James A. Brigagliano, Esq., Co-Acting Director of the Division of Trading and Markets, U.S. Securities and Exchange Commission
  • Mr. Frank Hatheway, Senior Vice President and Chief Economist, NASDAQ OMX
  • William O'Brien, Esq., Chief Executive Officer, Direct Edge
  • Mr. Christopher Nagy, Managing Director of Order Routing Sales & Strategy, Ameritrade
  • Mr. Daniel Mathisson, Managing Director and Head of Advanced Execution Services, Credit Suisse
  • Mr. Robert C. Gasser, President and Chief Executive Officer, Investment Technology Group
  • Mr. Peter Driscoll, Chairman , Security Traders Association
  • Mr. Adam C. Sussman, Director of Research, TABB Group

Senator Kaufman requests review of market structure

"...The SEC’s review should be all-encompassing, reviving old ideas and examining new ones: should markets be centralised or decentralised; should we separate the markets based on investor types; what should be the role of market makers; what role might there be for real time risk management?

At a minimum, a few simple themes should guide us to a regulatory framework that permits vigorous competition while substantially reducing the possibility of a two-tiered trading network, where long-term investors are vulnerable to powerful trading companies that exist not to value or invest in the underlying companies, but to feed everywhere on small but statistically significant price differentials.

First, we should reconsider the criteria for becoming an exchange or market centre because the market’s unhealthy fragmentation – and the high-speed trading strategies that thrive on it – are growing rapidly.

Second, we should consider rule changes that ensure the best prices are publicly available, not hidden from view in private trades. The strength of a free market is based on this public display. Accordingly, we should reduce “internalisation” (by insisting on meaningful price improvement in comparison to the public quotes or by granting the public quotes the right to trade first) and trading in dark pools (by reducing the permissible threshold for dark trading and defining indications of interest, and other quote-like trading signals, as quotes).

Third, we should root out conflicts of interest by ending payments from market centres that encourage orders to flow their way. The search for best execution by broker-dealers should not be subject to temptation from the highest bidders. Competition for market share includes liquidity rebates and direct access for hedge funds, which also deserves careful review.

Fourth, until regulators can measure execution fairness in milliseconds for stock trades of all kinds, the credibility of the markets cannot be assured. The audit trails and records of order execution in fragmented venues must be synchronised to the millisecond and made readily available in statistically understandable formats to the regulators and the public. Currently, while high frequency traders bank profits in milliseconds, the first column for time on the Rule 605 form, used by regulators to measure execution quality, reads “0-9 seconds.”

Fifth, regulators must also develop more sophisticated statistical tests, such as following volume patterns to gain a granular view of gaming strategies. Only then can regulators separate high frequency strategies that add value to the marketplace from those that inexcusably take value away.

As a nation, our credit and equity markets should be a crown jewel. Only a year ago, we suffered a credit market debacle that led to devastating consequences for millions of Americans. While we must redress those problems, we must also urgently examine opaque and complex financial practices in other markets, including equities, before new problems arise. It is essential to ensure the integrity of US capital markets."

"Sen. Ted Kaufman (D., Del.) is expected on Monday to call for the Securities and Exchange Commission to review all forms of current stock-market structure, signaling the broadest statement yet from a legislator in the continuing debate over the growth in high-frequency trading, a lightning-fast, computer-based trading technique.

In a letter reviewed by Dow Jones Newswires to be sent to SEC Chairman Mary Schapiro on Monday, Mr. Kaufman said regulatory moves in the past decade have had the unintended consequence of making the stock market too fragmented, possibly giving high-speed traders an advantage over retail investors. Mr. Kaufman wrote that there are now a series of potential conflicts of interest on Wall Street trading desks trying to serve both retail clients and high-frequency firms.

"I request the SEC undertake a comprehensive, independent 'zero-based regulatory review' of a broad range of market-structure issues, analyzing current market structure from the ground up before piecemeal changes built on the current structure increase the potential for execution unfairness," wrote Mr. Kaufman. In a zero-based regulatory review, each part of the current market structure would be reviewed comprehensively, as opposed to a traditional review of one particular type of market structure."

Senator Schumer on dark pools

"WASHINGTON, DC—U.S. Senator Charles E. Schumer (D-NY) will hold a conference call with Duncan Niederauer, CEO of the New York Stock Exchange (NYSE), on Tuesday, October 20, 2009 at 12:30 pm to urge the Securities and Exchange Commission (SEC) to institute a series of reforms to better regulate dark pools. Schumer will release a letter he is sending to SEC Chairwoman Mary Schapiro urging several different measures that would help ensure that dark pools and other nonconventional trading platforms operate on a more level playing field with the traditional stock exchanges, such as NYSE and NASDAQ.

Schumer and Niederauer will call for the SEC to revisit the decade-old Regulation ATS, which first allowed for non-exchanges’ entry onto the scene. Schumer will say that these alternatives can provide healthy competition for the exchanges, and have had significant benefits for retail investors. But now that they play such a central role in our marketplace they should be required to adhere to a more robust regulatory framework and bear their fair share of the costs for maintaining a market infrastructure, now borne disproportionately by exchanges like NYSE and NASDAQ.

The announcement will come one day before the SEC convenes an open meeting at which it will address several issues related to the operation of dark pools. The agency is expected to consider new rules along the lines of some of the reforms to be suggested by Schumer and Niederauer."

"... As you know, the Securities Exchange Act of 1934 (the Exchange Act) requires that exchanges bear the burden of self regulation, including market surveillance, capacity and systems compliance, and ensuring that exchange members comply with applicable securities laws and other rules, regulations and listing standards. Registered exchanges also must submit rule changes to the SEC for pre-approval, and are required to publicly quote and participate in price discovery.

In 1998, the SEC promulgated Regulation ATS with the goal of introducing competition to the New York Stock Exchange and Nasdaq, which dominated trading in the equities markets at the time. Regulation ATS promoted competition by making it easy to set up an alternative trading system – broker-dealers are simply required to file a notice with the SEC at least 20 days prior to beginning operations, the notice contains only a general description of the ATS’s proposed operation methods, and is not subject to prior approval by the SEC. Once they are operational, ATSs are not responsible for conducting market surveillance (FINRA conducts market surveillance for all broker-dealers operating ATSs) or for monitoring their users’ compliance with securities and other laws – they are only required to maintain an order audit trail in case FINRA or the Commission examines them.

Regulation ATS has had the desired effect: the number of ATSs has proliferated, and ATS market share has dramatically increased. Approximately 35% of trading volume now takes place off-exchange, up from only 9 percent in 2001. This competition has resulted in significant benefits, direct and indirect, to retail investors – liquidity is greater than ever, bid-ask spreads are lower than ever, and transaction costs have been reduced significantly.

But all of these benefits have come at a cost, as our capital markets have become increasingly fragmented, market surveillance has not kept pace and I am concerned that a large and growing portion of market activity takes place in dark or semi-dark spaces. These developments risk undermining the transparency that is so critical to maintaining fair and efficient markets, and have made it increasingly difficult – especially in light of technological developments that facilitate large volumes of trading at very high speeds – to conduct adequate market surveillance across all markets. Together, these developments risk undermining the fairness, transparency and integrity that have become hallmarks of the US capital markets.

That is why I am urging the Commission to consider the following proposals:

1. Establish Consolidated Market Surveillance

In 1975, Congress vested in the Commission the authority to create the National Market System, which provided a framework for connecting the growing number of trading venues. However, with the fragmentation of trading volume between different markets also came the fragmentation of market surveillance. Currently, each exchange has a separate arrangement for monitoring trading on its respective market, while FINRA conducts market surveillance of broker-dealers operating ATSs. I am concerned that this fragmented system of market surveillance makes it nearly impossible to monitor market manipulation, trading ahead of customer orders and other abuses at the same time that the fragmentation of our markets and technological advances make such abuses easier to carry out. For example, a trader can manipulate share prices through complex trading strategies at different exchanges and ATSs but escape unnoticed because no individual exchange is responsible for monitoring beyond its respective trading platform. I respectfully request that the Commission consider requiring that market surveillance be consolidated across all trading venues and that data from all exchanges and ATSs be submitted on a real-time basis to a consolidated audit trail. The costs of providing this consolidated surveillance would be covered by fees assessed by the consolidated regulatory authority on all trading venues on the basis of their respective proportion of total trading volume.

2. Require Broker-Dealers to Obtain Commission Approval Prior to Operating ATSs or Amending Their Operations

I believe the establishment of a trading venue is no light matter and that an ATS should demonstrate that it has adequate policies and procedures in place to ensure compliance with applicable laws and regulations by itself and its users, and to monitor system capacity, security, and contingency planning procedures as described below. Currently, in order to operate an ATS, a broker-dealer is only required to file a notice 20 days prior to commencing operation. Crucially, this notice procedure does not require Commission approval. I respectfully request that the Commission consider replacing this notice procedure with a robust approval process in order to determine whether the ATS would (i) ensure fair access and market transparency in accordance with existing law, (ii) comply with applicable market surveillance obligations and (iii) promote market stability and protect against systemic risks as well as risks posed to potential users of the ATS. I also respectfully request that the Commission require ATSs to obtain prior approval from the Commission for material changes to their operations.

3. Require ATSs to Have Procedures for Reviewing System Capacity, Security, and Contingency Planning

Regulation ATS only requires an ATS to adopt policies and procedures for reviewing system capacity, security, and contingency planning procedures if 20 percent or more of the average daily volume of any NMS stock has taken place on that ATS for at least four of the preceding six months. I respectfully request that the Commission consider eliminating this 20 percent threshold and require all ATSs to adopt such policies and procedures, provide a reasonably detailed description of such policies and procedures on Form ATS, and obtain the approval of the Commission prior to materially amending such policies and procedures.

4. Daily and Standardized Reporting

Presently, ATSs are required to report trades to the Consolidated Tape on a 90-second delay. They also report aggregate trade volume to the Commission on a quarterly basis. This trade volume data is not standardized – for example, some ATSs “double-count” by counting a matched order as two trades, while others treat a matched order as only one trade. I am very concerned that nobody seems to know the precise amount of trading volume that occurs in the non-displayed markets, and that this information is not available more frequently than quarterly.

I understand you intend to address post-trade reporting at your open meeting this week, and I respectfully request that the Commission consider requiring real-time reporting of trade information to the Consolidated Tape. I also respectfully request that the Commission consider requiring each ATS to report to the Commission, at the end of each trading day, aggregate trade volume by ticker symbol. This information should be reported in a standardized format that avoids double-counting of matched trades. Finally, I would urge the Commission to consider requiring public disclosure of aggregate daily trade volume for each individual ATS. I strongly believe that accurate and transparent reporting by ATSs will help reduce risks to market integrity and stability and greatly contribute to rebuilding public confidence in our markets.

5. Lower Percentage Threshold for Order Display and Review Fair Access Threshold

I am increasingly concerned that, as more trading volume moves onto non-displayed markets, including so-called “dark pools” and internalized broker-dealer networks, a two-tier market is beginning to develop in which a large segment of the market does not participate in price discovery. Thus, even though dark pools are generally required to execute trades at the best “market” price as determined in the lit markets – i.e., the national best bid and offer – the very process by which that market price is determined may be impacted.

Currently, ATSs are only required to disseminate their quotes for any given NMS stock to the Consolidated Quotation System if five percent or more of the aggregate daily share volume of that stock has been traded on the ATS for at least four of the preceding six months. Individually, most ATSs do not trade in volumes even approaching this threshold, but in the aggregate they account for a significant and growing portion of trading volume, most of which does not contribute to the price discovery process. Accordingly, I respectfully request, at the open meeting scheduled for Wednesday, October 21, 2009, that the Commission consider lowering the public quoting threshold from five percent to one percent. However, I recognize the important role that certain ATSs fulfill by executing large block orders on behalf of institutional investors in a non-display environment, and I would urge the Commission to consider an exception to the one-percent threshold as may be necessary to facilitate such block execution services.

In addition, I respectfully request that the Commission review the current threshold for fair access requirements under Regulation ATS, in order to determine whether those thresholds are meaningful in light of current trading volumes on ATSs.

6. Treat Actionable Indications of Interest as Firm Quotes Under Regulation NMS

I understand that the Commission intends to address so-called “actionable indications of interest” at this week’s open meeting. As you know, I feel that so-called flash orders undermine the fairness and transparency that are hallmarks of our markets, and I strongly support the rule proposed by the Commission at its open meeting last month that would effectively eliminate flash orders. However, I believe that certain “actionable” indications of interest (IOIs) operate similarly to flash orders. These IOIs bear virtually all the indicia of a firm quote, but are not required to be treated as such under Regulation NMS. As a result, very detailed information about potential order flow is exchanged among a small group of market participants, presenting even greater opportunities for abuse as flash orders. This anomaly should be eliminated. While many indications of interest are perfectly legitimate, and contribute to the efficient functioning of the non-lit parts of our markets, I believe that IOIs that walk and talk like firm quotes should be treated as such under Regulation NMS.

Accordingly, I respectfully request that the Commission consider, at this week’s open meeting, classifying such actionable indications of interest as firm quotes that must be disseminated to the Consolidated Quotation System (assuming the applicable volume thresholds are met). Combined with the reduction of the volume thresholds for order display described above, this proposal will result in bringing significant additional trading volume into the lit markets where it will participate in price discovery, thereby bolstering the efficiency and transparency of the markets."

SEC oversight

SEC Chairman on dark pools

" ...Finally, we — at the SEC — are also looking into dark pools of liquidity.

"...As you know, our markets are growing ever more sophisticated, with greater differentiation among the products and services offered. While this is a natural part of a dynamic market, regulators must be alert to whether, when niche products or services begin to take on larger market share, their effects on the broader market should raise concerns.

Dark pools generally refer to automated trading systems that do not display quotes in the public data stream. Although dark pools must promptly report their executed trades to the public, the trade reports do not identify the particular dark pool that executed the trade. As a result, it can be difficult for the public to assess the source of liquidity in a given stock.

Dark pools are intended to help market participants preserve anonymity and engage in transactions without moving the market. There are legitimate reasons for market participants to seek these trading goals. Over time, however, the volume of trades executed through dark pools has increased, raising, in turn, the potential for dark pools to detract from the quality of public price discovery mechanisms.

As dark pools divert an increasing volume of order flow away from the public quoting markets, the potential for market fragmentation is a concern. Also, where there is less publicly-available information about the trading practices of significant markets, there may be more opportunities for information to be leaked only to favored market participants. For these reasons, the SEC is considering whether dark pools need more light.

For example, some so-called dark pools in the U.S. are not really dark for all market participants. Rather, they transmit electronic messages to selected market participants that convey valuable information about their available liquidity.

The widespread use of these messages, often referred to as “indications of interest,” could create the potential for significant private markets to develop that exclude public investors. Such a two-tiered market would be inconsistent with the fundamental principles of fairness and efficiency that guide U.S. market structure policy.

We have recently begun an in-depth review of multiple market structure issues given the rapid advancements in technology. In addition to our recent actions with regard to flash orders and our current focus on dark pools, we will also examine high frequency trading, direct market access and co-location.

While we understand that there will always be trading and information asymmetries, we seek where possible, to eliminate inequities in the marketplace. Dark pools of course, are not a US phenomenon alone, and IOSCO has taken notice. As each jurisdiction considers whether and how to address dark pools and other market innovations, we will all benefit from understanding each other’s views and experiences through IOSCO.

SEC proposes new rules for dark pools

"To make trading through dark pools more transparent, the SEC's proposals generally would require that information about an investor's interest in buying or selling a stock be made available to the public instead of just a select group operating with a dark pool. The proposals also would require that dark pools publicly identify that it was their pool that executed the trade.

"Today's proposals are intended to prevent the development of a two-tiered market in access to pricing information, further promote displayed liquidity, and enhance transparency of trade information," said James Brigagliano, Co-Acting Director of the Division of Trading and Markets.

The SEC's proposals address three specific concerns related to dark pools:

  • The first proposal would require actionable Indications of Interest (IOIs) — which are similar to a typical buy or sell quote — to be treated like other quotes and subject to the same disclosure rules.
  • The second proposal would lower the trading volume threshold applicable to alternative trading systems (ATS) for displaying best-priced orders. Currently, if an ATS displays orders to more than one person, it must display its best-priced orders to the public when its trading volume for a stock is 5 percent or more. Today's proposal would lower that percentage to 0.25 percent for ATSs, including dark pools that use actionable IOIs.
  • The third proposal that would create the same level of post-trade transparency for dark pools - and other ATSs - as for registered exchanges. Specifically the proposal would amend existing rules to require real-time disclosure of the identity of the dark pool that executed the trade.

In its proposals, the Commission is seeking public comment and data on certain issues relating to dark pools. Dark pools of liquidity are one of several issues that the Commission is currently considering as part of its broad review of equity market structure.

Responses to the Proposed Rules (Kaufman, Themis)

From Senator Ted Kaufman:

Two months ago, I wrote a letter to SEC Chairman Mary Schapiro calling on the SEC to undertake a comprehensive “ground up” review of the U.S. equity market structure, including dark pools, high-frequency trading, flash orders, co-location of servers at the exchanges, direct market access, liquidity rebates, and payment for retail order flow. Today’s open meeting and rule proposals on dark pools, coupled with the proposed ban on flash orders issued last month, demonstrate that SEC Chairman Mary Schapiro and the Commission are taking this review seriously.

I support the three amendments to the rules outlined by the Commission today, in that they are consistent with suggestions I have made in the past to address dark pool concerns: defining indications of interest as quotes, lowering threshold limits on dark pools, and stricter reporting requirements. We need a comprehensive review, but that should not prevent the SEC from moving forward to adopt obvious improvements supported by evidence.

At the same time, these issues cannot be considered in isolation, as we already face systemic market structure problems resulting from the unintended consequences of prior rules. The growing volume in dark pools itself, for example, is an unintended consequence of Regulation ATS. Every time the Commission squeezes one side of the balloon, a bulge appears on the other side. The SEC must be conscious of those effects as well.

Banning flash orders and imposing limits on dark pools should not be the end of the story, nor should they be seen as sacrificial lambs offered up by a substantial majority of Wall Street players as the price to ward off deeper review.

Chief among the systemic issues that must be carefully reviewed is high frequency trading, which now makes up over 70% of the daily market volume. The SEC needs to closely review these strategies -- whether employed in dark pools or the public markets -- to ensure that high frequency traders are not able to take advantage of the long-term investors who are the backbone of our capital markets. It is the SEC’s mission to protect long-term investors, who care about the valuations of the underlying companies, not those who quest for trading profits achieved in milliseconds.

As I have said frequently, I’m all in favor of liquidity in the markets – but when it works against transparency and fairness, transparency and fairness must win. As a Commission staffer said at today’s meeting in response to a Commissioner’s question: spreads have narrowed, but prices quickly move back and forth, and high-speed professional investors are better able than retail investors to take advantage of those price impacts.

Moreover, I’m deeply concerned that high frequency trading, left unchecked, could develop into a systemic risk, becoming simply too big and too fast to regulate. Direct access to the exchanges by hedge funds -- which still are unregulated entities and which employ high frequency strategies without even the checks associated with rules applicable to broker-dealers -- also increasingly jeopardizes systemic stability.

Achieving effective and efficient regulation of these profit-maximizing strategies will not be easy. Already many industry participants have opposed even a mere review of high frequency trading. Their position seems to be “nothing to worry about, move along.”

Given all we know about recent history, we cannot blindly accept these assurances. I hope the SEC will continue to press for meaningful reforms, and so I’m pleased that Chairman Schapiro at today’s meeting mentioned these issues as important to the Commission’s review. When the news reports that even sophisticated institutional investors are asking their major broker-dealers “not to simply hand over their orders on a silver platter” to high frequency traders, we know clearly that investor confidence in the fairness of the market has been jeopardized.

Our credit and equity markets should be a national treasure. They should direct capital to its highest uses – profitable, job-creating investment, not opaque, fast-buck speculation. We need a careful review of high frequency trading, dark pools and other practices in a comprehensive “ground up” review of how our equity markets function. Only then can the SEC restore investor confidence, establish a level playing field for all investors, protect the public from another systemic failure, and secure the foundations of our economic future.

And the response from Themis Trading:

We believe the SEC is striking an appropriate balance by shining a light on so much of the murky and small-execution size dark pools, and forcing their flow to the public quote, while still acknowledging the role of block trading and innovation for the institutional and retail community alike. We also appreciate the SEC looking broadly at our market structure as it exists today, and broadly looking at issues like co-location, specifically in how it relates to unfair advantages in the delivery of market data. We expect overall liquidity to not be materially affected, and perhaps the spreads even tighten, especially in the lower capitalization stocks.

Beginning with REG ATS in the late 90’s, the SEC has had the stated goal of transparency, and equal access to pricing by all market participants. Unfortunately, with decimalization and REG NMS, the velocity of trading has skyrocketed. While this spawned some innovative products, nevertheless it has fragmented the market place and hurt the price discovery process in an unintended way. Never did they expect there would be over 30 dark pools trading over 20% of the volume, with a great number of them being internalization engines. And never did they intend for such a large percentage of the order flow to be regulated in a different way than orders on public exchanges. Multi-tiered markets were wrong in 1998, and they are wrong today.

Sponsored access could pose "systemic risk"

"Sen. Ted Kaufman called Friday for the Securities and Exchange Commission to take immediate steps to stop so-called sponsored access, a common practice in the hot area of high-frequency trading.

In a letter to SEC Chairman Mary Schapiro, the Delaware Democrat said sponsored access, in which high-frequency traders use a brokerage firm's computer identification code to trade directly on an exchange, "creates systemic risk today."

Critics of the practice say a high-frequency firm using sponsored access, also known as naked access, without proper risk controls could trigger a destabilizing cascade of trades that result in massive losses for firm as well as the sponsoring broker.

Often the firms paying for sponsored access haven't undergone or paid for the same registration process as regulated brokers.

In an October speech that was delivered before the Securities Industry and Financial Markets Association, Ms. Schapiro said the agency expects to look more closely at sponsored access.

"I liken it to giving your car keys to a friend who doesn't have a license and letting him drive unaccompanied," she said.

SEC spokesman John Nester declined to comment on Sen. Kaufman's letter.

High-frequency trading accounts for more than 50% of stock-trading volume, according to industry estimates.

Earlier this year, the SEC moved to ban flash trading, which gives some high-frequency players an advance look at market flow.

Industry comments on the move are due Monday.

Sen. Kaufman said the agency shouldn't wait for a comprehensive review before suspending sponsored access.

A vocal critic of high-speed trading practices, Sen. Kaufman wrote a letter to the SEC in August calling for a broad review of market structure, which the senator said facilitated widespread unfairness and conflicts of interest."

World Federation of Exchanges on dark pools

Now that Flash trading is practically a thing of the past, everyone's attention is shifting to dark pools. And if the just released letter by the World Federation of Exchanges is any indication, dark pools' days could be comparably numbered.

Dark pools are off-exchange trading venues, or Alternative Trading Systems (ATS) which are largely unregulated, allowing participants to transact in large blocks without disclosing trading intentions until long after the trade has been executed if at all. For the most part dark pools are run by investment banks themselves, with Goldman's Sigma X being a highly visible (pun intended) example, and one extensively discussed previously on Zero Hedge. The one prevailing characteristic of dark pools is the secrecy of transactions, revealed only to select transacting members. In their letter, the WFE warns that the "heightened opacity of these platforms in many countries inhibits price discovery and may lead to negative outcomes, including increased market volatility."

And while proponents of dark pools use the now all too generic explanation of enhanced liquidity, the question of whom this liquidity benefits is still an open one. The preliminary answer: only those who have access to such ATS venues benefit from the liquidity, which inherently is predominantly provided by the inventory of the ATS operator. As such it is merely a means of a firm like Goldman to offload proprietary positions to select clients.

Some notable concerns with dark pools stems from the very nature of the SEC's Regulation ATS "Fair Access Rules" which basically state that dark pools are non-democratic hierarchical organizations, with the ATS having veto power over who is allowed to trade on any given venue.

Probably the biggest complaint about dark pools has to do with the concept of actionable IOIs which are the practical (but not identical) equivalent of Flash orders on regulated exchanges. In an actionable IOI a firm seeking a bid or an offer will send out a ping to a subset of members, which never ends up in the public domain, and give the select dark pool participants a first and only look at whatever is about to hit the tape.

The WFE letter focuses on the same principles that Senator Kaufman has highlighted in his campaign for elimination of trading tiers and creating a level playing field.

There are two interconnected concerns of exchanges which merit the attention of G-20 leaders. First is the absence of a level playing field between exchanges and other entities performing some of the same or similar functions. Second is an erosion of price discovery arising from recent trends. As discussed below, these phenomena may be compromising the role of the public, regulated marketplace, and hampering exchanges' ability to fulfill their macroeconomic role. And expanding on the loss of the level playing field:

In many jurisdictions, the introduction of alternative order execution platforms has led to significant internalization of order flow and related practices. These practices limit the visibility of orders, hampering investors' ability to respond to them and diluting the price discovery process. These practices also reduce the market participants' and regulators' ability, in many instances, to see overall market activity and may impact the conduct of proper market surveillance.

At the end of the day, all investors need to have confidence in the reliability of information reflected in the prices at which securities transactions occur. The heightened opacity of certain trading venues in many countries inhibits price discovery and may lead to negative outcomes, including increased market volatility.

The WFE Board believes that the current environment is creating an unequal distribution of the costs of providing a capital markets infrastructure at the expense of regulated markets and to the advantage of alternative trading venues. Regulated exchanges welcome competition, but it should not be structured in ways that can affect the quality of market operations and the soundness of the price discovery process. There have been new entrants with distinctive business models that have made significant contributions to our industry. The exchange industry is open to newcomers but it should be on a level playing field. And the WFE's recommendation to the G-20 leaders:

The WFE Board recommends that the G-20 leaders consult with investor organizations about how they would wish to see orders executed in the markets, and determine whether alternative trading venues have reducing the total costs of transacting by investors.

The WFE Board also asks G20 leaders to assure a level playing field for the responsibilities assumed by all securities order execution venues. This would remedy many capital markets uncertainties. assuring greater transparency, greater fairness, and a more level competitive field.

The WFE points out that divergence even within the dark pool venue propagation, distinguishing between exchange operated and external dark pool operations.

Recently, some exchanges have accommodated these demands by creating order types or opening segments that allow trading that is not immediately visible to the rest of the market. In the case of exchanges, this trading is nonetheless tied into the visible market's surveillance and position-monitoring in order to assure the oversight of total market operations.

Other execution venues also offering dark trading in so-called "dark pools," but their trading and clients' positions are not visible for surveillance purposes. Regulators have no way to evaluate the risks which may be inherent in the combined on-exchange/off-exchange dark pool activities, nor what effects they might have on the visible markets.

Taken together, the combination of the absence of a level playing field between execution venues and decreased market transparency is an unsettling development. The policies and practices that exchanges have developed to ensure fair, orderly markets are at risk of becoming less meaningful and less available to investors and listed companies. One could argue that here is where exchanges are hypocritical and one would be right. If the risk tolerance of an exchange operated dark pool if only mitigated by the fact that it is "regulated" by the SEC which is not only still trying to figure out what is going on 20 years ago, it would be remiss to state that the regulators will have any clue of any shady activity occurring on an exchange dark pool until it is far too late. Let's not forget that the SEC allowed Flash trading to exist only to seek to ban it several years later.

And while the pushback to the Flash ban has been relatively muted due to the lack of major market players who endorse it, the same can not be said of dark pools, which in effect positions two highly integrated and symbiotic players against each other. It would be amusing to watch the NYSE and Goldman Sachs, two integrated players in the market landscape, especially with the latter providing well over 20% of the NYSE open exchange liquidity via SLP, yet Goldman also dominating the dark pool arena via Sigma X. Is the trade off to the NYSE to antagonize Goldman, especially with Mr. Niederauer at the helm, a former Goldmanite, and potentially lose billions in exchange fees if it were to unwind the SLP monopolized by Goldman? Of course not. Which is why this push for yet another domino in the tiered market system to be toppled will have to come via regulatory and legislative intervention. Senators Kaufman and Schumer - the investing world is looking to you to continue your pursuit of a "level playing field" - your next step is the elimination of the entire dark pool concept."

Dark pool trade reporting consortium

With dark pools under the regulatory microscope, Nyse Euronext has struck a deal with five firms behind ATSs and off-exchange market centres to print trades made on the venues on the reporting facility it operates with Finra and display daily activity on Nyse.com. The exchange says Barclays Capital, Getco, Goldman Sachs Execution & Clearing, Knight Equity Markets and UBS have already volunteered to begin reporting activity on their respective ATSs and off-exchange venues to the facility next month.

Other firms have expressed interest in the initiative and are currently setting up the technology to start participating in the programme over the next few weeks.

The daily trading activity volume published by the Finra/Nyse TRF will be based on trades reported to it, which follow the watchdog's reporting rules. Nyse Euronext says that basing the published volume strictly on trade reports will address some of the problems associated with voluntary reporting by ATSs of their own volume, such as counting both sides of a trade, and counting trades that are routed but not executed.

The move by Nyse and broker-dealers comes as the Securities and Exchanges Commission probes dark pools amid concern over its impact on transparency and market fragmentation. The watchdog is set to meet to discuss the issues tomorrow.

Joseph Mecane, chief administrative officer, US markets, Nyse Euronext, says: "This is an example of Nyse Euronext and the industry working together to develop a positive solution to address the lack of understanding regarding the extent and nature of 'dark pool' trading, which has been a concern for regulators and legislators."

Frank Troise, head, equities electronic product, Barclays Capital, adds: "This initiative is an important step toward the standardization of trade volume reporting across ATS venues. Industry participants will be able to make more informed order placement decisions and thereby improve their execution quality."

Nasdaq chief thinks dark pool action likely

The Securities and Exchange Commission may take action against dark pools as regulators seek to increase the transparency of the private trading networks, Nasdaq OMX Group Inc. Chief Executive Officer Robert Greifeld said today.

Dark pools, or markets that don’t display quotes to the public, have come under scrutiny from lawmakers, investors and traders who argue they make markets opaque. Investors executing larger orders use the platforms as a way to avoid revealing details of their orders, which could sway share prices.

“You’ll see some movement on dark pools,” Greifeld said today at a conference in New York. While there are reasons for markets “not to be transparent,” he said, “if you’re not adding value that the transparent market doesn’t provide, then you’re free-riding.”

The SEC is reviewing market issues ranging from dark pools to high-frequency trading, the practice of using computers to automatically buy and sell thousands of shares a second. Regulators proposed a ban last month on flash orders, which allow a group of traders to see an order a split-second before it’s routed out of a market, after Democratic Senator Charles Schumer of New York urged a review and later said the practice could undermine fairness and transparency. The European Commission also plans to examine dark pool share trading.

Regulators will review “additional measures” on dark pools this fall, SEC Chairman Mary Schapiro said in a speech last month. Dark pools have increased their share of trading in the U.S., rising to about 12 percent of the nation’s market share last month, according to an estimate by Tabb Group, a financial-market research and advisory firm in New York.

High-frequency trading “clearly brings value to the market” because it provides liquidity, Greifeld said. Those traders remained in the market, serving as the counterparty to trades, even as the Standard & Poor’s 500 Index fell 38 percent in 2008, its worst year since the 1930s.

The proposal on flash orders requires a second vote at a later public meeting to become binding. The SEC is accepting public comments.

JP Morgan to launch new dark pool

"JP Morgan Chase is on the verge of launching a new dark pool, sources close to the big bank say.

Called JPM-X, the platform is based on technology built by Bear Stearns, and will replace an earlier dark pool called Lighthouse.

JP Morgan launched Lighthouse early in 2008, just before the bank acquired a floundering Bear Stearns.

Lighthouse is still operational as an internal cross, sources say, but is in the process of being decommissioned. The system was never registered as an alternative trading system.

JPM-X, on the other hand, is an ATS. It is expected to be considerably larger than Lighthouse due to the acquisition of Bear Stearns. The deal brought to JP Morgan a large prime brokerage operation as well as Bear’s clearing and retail businesses.

In at least one critical respect, JPM-X will operate in fundamentally different fashion from Lighthouse: it will not transmit indications of interest.

“We do not send out IOIs,” Brett Redfearn, JP Morgan’s global head of liquidity, said at a recent industry conference. “We believe—just like flash orders—there is some leakage associated with the practice.”

Some dark pool operators send out electronic messages to other dark pools or liquidity providers noting the presence of an order in their pool. Many in the industry find the practice harmful.

(New rules proposed by the Securities and Exchange Commission could sharply curtail the practice.)

A year-and-a-half ago, JP Morgan believed transmitting IOIs was a good way to increase the chances of finding a match in its pool. Lighthouse was built as both an internal crossing mechanism as well as a seeker of external liquidity. It was called Lighthouse because it scanned other dark pools much as a real lighthouse scans the darkened seas.

Redfearn, who was previously with Bear Stearns, took over JP Morgan’s electronic trading department after the merger, replacing Carl Carrie.

Sources say the system was originally built by Bear Stearns, but has been significantly augmented since the merger. The system is operational and is expected to be launched soon. JP Morgan executives would not comment for this article.

Goldman Sachs on dark pools

"Goldman Sachs Group Inc., the most profitable securities firm, defended for U.S. regulators dark pools, short-selling, high-frequency trading and other market practices that have been criticized by lawmakers.

Goldman told the Securities and Exchange Commission that computer-driven trading and an increase in stock transactions that occur off public exchanges has reduced consumer costs, increased competition and brought more liquidity to markets.

“The investing community (especially retail) has benefited from the evolving market structure and industry competition,” Goldman Sachs said in a summary of the 55-page report submitted to the agency.

The SEC is under pressure from lawmakers such as Democratic U.S. Senators Charles Schumer and Ted Kaufman to rein in some of the fastest-growing segments of U.S. markets. Kaufman in August asked the commission to review seven practices including high- frequency trading, saying investor confidence may be eroded.

Executives from New York-based Goldman met with staff for Commissioner Luis Aguilar last month and sent a copy of the report, according to an Oct. 22 notice on the SEC’s Web site.

Trading on dark pools, off-exchange platforms that don’t display public quotes, has more than quadrupled to 9.4 percent of all U.S. equity volume in the past three years, according to Tabb Group LLC. High-frequency traders, whose computer programs buy and sell shares up to 1,000 times faster than the blink of an eye, account for about 46 percent of daily volume.

Goldman, which operates the Sigma X dark pool, in the document identified five “myths” associated with the platforms. The bank said it’s a misconception that dark pools create a “two-tiered market structure” to the detriment of retail investors and that platforms that don’t publicly display orders are a new phenomenon."

Goldman prefers to "internalize" trade flow

"...New York-based Goldman also swept the competition in the three regional categories: Asia, Europe and North America. Last time, Goldman placed sixth worldwide and second in Europe; it was a no-show in the top five in North America.

“They have the most developed and advanced electronic systems,” says Roger Freeman, an analyst who covers brokerages and exchanges at Barclays Plc in New York. “They can get some of the fastest execution times on trades, thereby minimizing some potential costs.”

Goldman is also able to match buy and sell interest under its own roof because it receives orders from a mix of mutual funds, asset managers and other institutional clients. That makes it less likely that hints about trading intentions will leak out to the market, says Paul Russo, Goldman’s head of U.S. equities trading and co-head of global equity derivatives.

“Any time a client trades with us, we try to match them off against our natural internal flows,” he says. “That way we can minimize the trading footprint we leave in the marketplace.”

Goldman’s technology and its access to a large pool of potential buyers and sellers help it to search for -- and find -- liquidity at the best price for customers.

“The winning brokers coordinated across trading desks within their company,” says Kevin McPartland, a senior analyst at New York-based Tabb Group. “Their software-development and server technology teams worked together efficiently.”

Charlotte, North Carolina-based Bank of America Corp., which acquired Merrill Lynch & Co. for $29 billion in January 2009, shot to second place from fifth in the recent global ranking. Merrill, the world’s biggest brokerage at the time of the purchase, had placed seventh previously..."

Dark pool ownership

Independent dark pools

  • Instinet
  • Investment Technology Group (ITG)
  • Liquidnet
  • NYFIX Millennium
  • Pipeline Trading Systems
  • Pulse Trading
  • RiverCross

Broker-dealer-owned dark pools

  • BNP Paribas
  • BNY ConvergEx Group (an affiliate of Bank of New York Mellon)
  • Citigroup - Citi Match
  • Credit Suisse - CrossFinder
  • Fidelity Investments Capital Markets
  • Goldman Sachs Execution and Clearing
  • Knight Capital Group
  • Merrill Lynch
  • Morgan Stanley
  • UBS AG Investment Bank
  • Ballista ATS (Ballista Securities LLC)

Consortium-owned dark pools

  • BIDS Trading
  • LeveL ATS

Exchange-owned dark pools

  • International Securities Exchange
  • The NASDAQ Stock Market
  • NYSE Euronext
  • BATS Trading
  • Direct Edge

Other dark pools

  • Chi-X

Dark pool aggregators

  • Progress Apama
  • ONEPIPE - Weeden & Co. & Pragma Financial
  • Xasax Corporation


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