NEW YORK - Despite their sinister-sounding name, dark pools of liquidity can be very beneficial to average investors by offering mutual funds and large institutional investors an efficient way to make large trades without impacting the market.
Unfortunately, the usefulness of dark pools has quickly exceeded the ability of authorities to monitor or regulate them. Many financial leaders are worried that the exploding popularity of these private crossing networks runs contrary to mutual funds' promise of transparency and should perhaps be scaled back a bit.
"Collectively, dark pools are too big and have become a victim of their own success," said Duncan Niederauer, chief executive officer of NYSE Euronext, at the Investment Company Institute's annual Capital Markets Conference in Manhattan.
Niederauer said approximately 40% of the trading that takes place in U.S. markets is opaque, unregulated and does not occur on organized exchanges. This growth could quickly become a matter of systemic risk. If the government intends to police the markets the right way, he said some agency or some form of a systemic risk council has to have 100% of trading information.
It is possible that dangerous, risky or illegal activity is taking place in dark pools, but regulators don't know enough to know whether anyone is cheating, Niederauer said.
"I'm not saying dark pools should go away, but I don't understand why the government isn't being tougher on this," he said. "We're not here to outlaw dark pools, but if they are going to exist, we should make sure we're keeping the investor in mind. After all, we're supposed to be encouraging transparency."
There is a perception among the public and in the press that dark pools are patently unfair to investors, said Ari Burstein, senior counsel of the ICI. The reality is that there are many different shades of gray among dark pools, and some are better than others.
"We find it disturbing when some of these venues are singled out for criticism by those who don't fully understand the function that they fill or the investors that they serve," said Paul Schott Stevens, ICI president and CEO.
Mutual fund advisors are charged with controlling costs in order to deliver performance and fulfill their fiduciary duties, but it's also important to control the cost of market impact, or the amount by which the price of a stock moves against the trader during the time it takes to execute a trade, Stevens said.
"The larger the trade, the greater the risk of an adverse price movement," he said.
Alternative trading networks like Liquidnet are highly praised among mutual funds and institutional investors for their ability to provide necessary liquidity while helping investors "hide their hand," said Joseph Gawronski, president and chief operations officer at Rosenblatt Securities Inc.
In addition to a few independent dark pools, several major fund companies as well as major exchanges in the U.S. and abroad have their own dark pools. Because mutual funds use dark pools to trade, mutual fund investors benefit from these markets.
"Over-generalizing and over-villainizing such a large portion of the market is not going to be productive," said Joseph Mecane, executive vice president and chief administrative officer for U.S. markets at NYSE Euronext. "We try to step back every few months and take a look at the direction of developments."
Mecane said the Securities and Exchange Commission tried to inject competition into the marketplace a few years ago, but the world got very complicated very quickly.
"The SEC doesn't want to impede the ability of institutions to source liquidity, but we probably let the pendulum swing too far," he said.
"There has been a massive shift in the competitive environment in the last few years," said William Baxter, senior vice president of Fidelity Management and Research. "U.S. equity markets are as efficient as they've ever been, but it's the area inbetween, that we're calling gray, that's up for debate."
Dark pools of various shades can source their liquidity from a variety of places, and the use of algorithms to link the upstairs and downstairs markets together can make it increasingly difficult to draw the line between what is dark and what is not so dark, Baxter said.
"We need a way to distinguish between the dark pools," Burstein said.
"Whether it's a lit market, a dark market or a semi-lit market, the notion of a two-tier marketplace doesn't exist now," added Robert Gasser, president and CEO of Investment Technology Group.
Shine a Light
If regulators are serious about detecting systemic risk in the future, they will need to shine a little light into the murky areas of dark pools.
"We recognize the reality that large institutional orders can have undue market impacts, but we are very concerned that the networking between dark pools could lead to the creation of dark liquidity and dark exchanges," said Eric Noll, executive vice president of transaction services at Nasdaq.
"The original intent was to facilitate institutional orders without market impact, but dark pools are not contributing to market transparency," Noll said. "What looks like an order should be treated like an order."
Industry leaders can't stress enough that any regulatory changes to such a large market segment and trading style should be taken with great care.
"As we all know, there can be unintended consequences to regulations," Gasser said. "It's like trying to unravel the inner workings at a sausage factory. Sometimes the individual ingredients aren't too attractive, but the finished product is edible."
NYSE's Niederauer said open exchanges are currently burdened by a lot of costs and regulatory requirements that other trading venues are free of, and these areas must be remedied in order to create a more level playing field.
"We have 30% of the market share, but we pay 80% of the costs," he said. In the interest of fairness, everybody should contribute to the cost of an oversight regulator, he added.
"We're not trying to eliminate the competition, but we're kidding ourselves if we think we can catch those with more sophisticated strategies," Niederauer said. "If you allow those pools to exist, why would anybody want to be registered?"
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