Regulators on two continents have noticed that too much trading in stocks takes place out of sight.
Tomorrow, European finance ministers plan to endorse legislation that would force transactions in privately owned venues known as dark pools into an organized trading system. Meanwhile in the U.S., the Financial Industry Regulatory Authority, the brokerage industry’s self-regulator, sent letters last month to 15 firms, seeking information on how they police their dark pools and what they disclose to customers.
The proliferation and growth of dark pools should concern anyone who buys or sells shares, not to mention workers whose retirement accounts hold stocks in mutual funds. Evidence is mounting that trading in dark pools increases the odds that buyers and sellers won’t easily find each other, so investors can lose out on the best possible prices.
The companies that own dark pools haven’t exactly made it easy to figure out what happens on their private trading systems: Credit Suisse Group AG, whose Crossfinder service is the biggest U.S. dark pool, in April stopped reporting the number of transactions it processes. About a dozen other dark pools already keep mum about their trading, and there is nothing to stop the rest from joining the silence. This would further obscure the transparency that has helped make American capital markets the most appealing in the world.
Dark pools arose in the 1980s when the Securities and Exchange Commission said brokers could bring together buyers and sellers to trade anonymously. Rather than routing customer orders to the traditional exchanges, brokers could send them to an outside trading service or execute orders on their own internal systems, pocketing the spreads on prices and trading fees. Today, as much as 40 percent of trading in U.S. equities takes place away from the public stock exchanges.
Not surprisingly, trading on dark pools and brokers’ internal trading systems has exploded in recent years. Most of the increase has come at the expense of U.S. stock exchanges, where volume has fallen more than 30 percent in the past three years, according to data compiled by Bloomberg. There even are signs that dark pools are picking up the business of small investors, based on research that shows the average dark-pool transaction involves just 200 shares.
To their credit, dark pools have forced the stock exchanges to be more competitive through technological innovation. But the growth of dark pools also reflects the higher operating and compliance costs of their heavily regulated exchange rivals, an obvious benefit for firms such as Goldman Sachs Group Inc., UBS AG and Barclays Plc, which own three of the five largest private trading services.
All this fragmentation means that buyers and sellers aren’t meeting in a central location where information is shared, endangering the price-discovery function on which efficient markets depend.
The SEC, however, doesn’t have the authority to oversee dark pools the way it does exchanges, which have public-utility-like obligations. Exchanges match supply and demand, make buy and sell quotes publicly available, post trading prices, and police their markets for fraud and insider trading.
Dark pools, by contrast, essentially piggyback, at minimal cost, on quotes set by the New York Stock Exchange, the Nasdaq Stock Market or the U.S.’s 11 other stock exchanges. The dark pools are under no obligation to provide data that the broad market uses for price discovery. What information they do make available tends to fail the fairness test: Price quotes are sometimes sent to select investors, giving them an unfair advantage. Regulators are also concerned that high-frequency traders are placing orders on the open exchanges in order to influence prices in dark pools to their advantage.
If this were only a dispute between commercial interests, we could leave the exchanges to duke it out with the dark pools. The reality is that exchanges provide a public service. In the U.S., legislators recognized this in the 1930s, when the first laws governing exchanges and protecting investors were adopted. (Bloomberg LP, parent of Bloomberg News, owns a stake in a company, Bids Trading LP, which operates a dark pool.)
Although Europe’s regulators are pursuing one remedy, Canada might serve as a better model for the U.S. Last year, Canada required dark pools either to offer a superior price to that of the exchanges or to limit trading to large blocks of shares. Since then, buy-and-sell spreads have narrowed by 25 percent, and sharp price swings have declined.
Were the U.S. to adopt a price-improvement rule it might limit the ability of dark pools to leech off the quotes the exchanges generate at great expense.
Regulators should also consider restricting or banning the practice of sharing data with select clients, or require broad quote dissemination. Finra must also be more vigilant amid signs that dark pools have shared clues about customer trading intentions with proprietary traders working for the Wall Street firms that own some of the dark pools.
Dark pools aren’t going away. Regulators need to ensure that their further growth doesn’t cause unacceptable harm to U.S. financial markets.
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