Media Room

Shadows fall over dark pool trading practices

Tuesday, December 20, 2011



The Securities and Exchange Commission’s recent settlement with a dark pool operator has raised unsettling questions about the use of alternative trading systems.

The operator of the dark pool, Pipeline Trading Systems, billed itself as providing a refuge from “predators”, but the venue failed to disclose that the vast majority of orders were filled by an affiliate that had access to specialised information about trades, according to the SEC’s order. Pipeline and its top executives paid $1.2m to settle the charges, without admitting or denying wrongdoing. The two top executives at the venue’s parent company, Pipeline Financial Group, stepped down shortly after the settlement was announced in October, and a new chairman has promised to restore investors’ trust.

Dark pools aim to allow investors to make large trades without giving away their identity, the size of their trade and even whether they aim to buy or sell. The secrecy is meant to protect investors from prices moving against them.

Alternative trading systems such as dark pools have been credited with reducing institutional investors’ commission costs and in some cases, allowing them to obtain better prices than they could on public exchanges. Their growth has accelerated since the mid-1990s, in response to technological advances that allowed broker-dealers to more easily match buy and sell orders.

Investors’ desire to keep their trading intentions secret is nothing new, says Tim Mahoney, chief executive of dark pool operator BIDS Trading. Institutional investors have always had access to “dark” liquidity through traders who would keep the details of orders hidden.

“Hidden liquidity has been around as long as people have been trying to buy and sell stock,” Mr Mahoney says. “Most people see the wisdom of using dark liquidity to trade size [in large volumes].”

However, some investors have raised concerns about dark venues’ lack of transparency and their potential vulnerability to abusive practices.

In light of the recent charges against Pipeline, fund advisers must re-evaluate how and why they choose the dark pools they work with, and review the dark pools’ disclosure documents, although the allegations seem to indicate there is no guarantee those are always accurate, says Andrew Donohue, a partner at Morgan Lewis & Bockius.

At the very least, Mr Donohue says, dark pools “should do what they’re saying they’re doing. They shouldn’t use an affiliate without saying they are”.

There is a more fundamental concern, says Dennis Kelleher, chief executive of Better Markets, a Wall Street watchdog. “The question is, why are we in dark pools in the first place?”

“The only reason you have dark pools is because trading is being driven from the open exchanges almost exclusively because of the predatory behaviour of high frequency traders and computer-driven traders.”

Dark pools made up nearly 12 per cent of consolidated US equity trading volume in October, up from less than 4 per cent in January 2008, according to Rosenblatt Securities, which tracks dark pool activities. Pipeline, one of the 18 dark pools tracked by Rosenblatt, handled an estimated 0.0034 per cent of consolidated volume in October, according to Rosenblatt.

Dark pools’ increase in popularity has coincided with the rise of high frequency traders, who use super-computers to make trades in microseconds, racking up gains off even the smallest movements in the markets. Regulators have expressed concern that high frequency traders can use technology to game the system, getting ahead of slower-moving investors and profiting at their expense.

Meanwhile, proponents argue the traders provide valuable liquidity.

“The net effect of high frequency trading has been positive,” says Justin Schack, managing director at Rosenblatt, which estimates that high frequency firms account for between half and two-thirds of US stock market volume.

Though markets are more complex than they were before the rise of high frequency traders and dark pools, they deliver better trading outcomes, Mr Schack says. Nonetheless, he acknowledges there are potential pitfalls to using alternative trading venues.

Brokers can face conflicts of interest when deciding which venue to use; one venue, for example, may charge a commission for a certain trade while another would issue a rebate, Mr Schack says. The brokers’ rebates or fees are not passed through to the institutional client, so the broker can have an incentive to choose the least expensive venues, not necessarily the ones with the most liquidity or the best prices, he adds.

“A lot of head traders we deal with are calling us and saying, ‘My board is asking me about this, my CIO [chief investment officer] is asking me about this – what do I need to know about this? What do I need to do differently?’” Mr Schack says of the Pipeline settlement.

But Mr Kelleher of Better Markets argues that mutual funds that use dark pools because they are concerned about being exploited by high frequency traders on public exchanges are like a person who gets pick-pocketed in broad daylight deciding to walk down a dark alley. The victim should call the cops, he says.

Fund directors and other industry insiders should demand regulators curb traders’ abusive practices, whether they occur in public or dark venues, Mr Kelleher says. “Nothing is going to happen to the high frequency traders until the big market participants on the buyside say, ‘This has got to stop’”.


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