New York State Attorney General Eric Schneiderman
is getting more serious about regulating and possibly prosecuting opaque, off-exchange trading.
"Upstairs" or "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.
These highly unregulated strategies involve exchange-listed securities that are traded off the public exchanges by private brokerages. They are subject to less regulations and public disclosure requirements than that imposed on public exchanges.
Opaque pricing and terms are thereby granted to selective participants. This allows large institutions, such as mutual funds, hedge funds, pension funds and insurance funds, to camouflage their trading strategies and unfairly maximize profits at the expense of other market participants.
Haoxiang Zhu, a financial economist at the MIT Sloan School of Management and the author of a new paper in the Review of Financial Studies, cites a study in which 71 percent of financial professionals believe dark pools are "somewhat" or "very" problematic in establishing stock prices.
Schneiderman would like to change this by having trading transactions determined by price instead of market timing, which unfairly benefits high-frequency traders. This methodology was recommended by economists at the University of Chicago.
The New York Attorney General is also exploring how we can limit unfair access to market-sensitive information and early receipt of exchange-based orders through server co-location, strategies employed by high-frequency traders to gain an unfair advantage.
Thus far, regulators have done little to curb this behavior. High-frequency trading accounts for more than 50 percent of all trading volume.
The Commodity Futures Trading Commission (CFTC) is now investigating financial discounts given by exchanges to high-volume traders. These discounts undermine the overall competitiveness of the system.
In addition, the CFTC is examining whether exchanges have engaged in coercive activities with high-volume commodity traders, such as crude oil traders, in an effort to keep their business and whether exchanges have made secret deals with trading firms without notifying other trading outfits in a timely and transparent manner.
Greater market transparency and access is critical for stable, long-term economic growth that promotes employment and income for the masses.
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