The U.S. stock market has fragmented into 11 public exchanges and roughly 45 alternative trading systems, most of them dark pools. Rules to limit dark pool trading have been put in place by Canada and Australia and the European Union is phasing in similar measures. Critics have complained that all traders are hurt by the fact that dark pools don’t make orders public but only post completed trades. The publication in March 2014 of “Flash Boys” by Michael Lewis led to questions over whether some dark pools were designed in a way that let high-frequency traders place bets knowing which way the market was about to go. That June, New York Attorney General Eric Schneiderman filed suit against Barclays, charging that it lied to customers about how much business its dark pool did with high-speed traders and how client orders were routed, charges Barclays denies. In August 2015, the SEC imposed a record $20.3 million fine on ITG for running a secret trading desk that used knowledge of customers’ dark-pool orders to trade for its own benefit. The agency had earlier fined UBS $12 million for violations at its dark pool. And the agency is developing rules to increase dark pool disclosures and may test a rule requiring that trades take place on public exchanges unless a significantly better price is offered elsewhere. The NYSE, meanwhile, has offered to cut trading fees sharply if all but the biggest orders are brought back to public exchanges.
Bonds, currencies and most other financial instruments are generally not traded on open exchanges, and there’s always been some non-public trading in the stock market. Old hands reminisce about “upstairs trading,” a euphemism for private, large-order deals. That was the exception: Since the SEC was formed in the wake of the stock market scandals that led to the panic of 1929, the agency has equated openness with fairness. Publicly shared bids and offers mean a level playing field, and the rapid sharing of price information is seen as central to the market’s role in the efficient allocation of capital. Dark pools arose in the 1980s, when the SEC allowed brokers to bring together buyers and sellers of big blocks of shares. Their recent growth has been driven by electronic trading and a SEC rule meant to spur competition and cut transaction costs that took effect in 2007. Dark pools can charge lower fees than exchanges because they are usually just one unit in a larger firm. (Not all the operators of alternative trading systems are banks: Bloomberg LP, the parent of Bloomberg News, owns one, Bloomberg Tradebook, which is registered with the SEC.) Along the way, their client base changed. Dark pools are not generally venues for big orders anymore — one study found that the average order size is now just 200 shares.
Proponents of traditional exchanges say the secrecy surrounding dark pools leaves the door open to abuses, as there’s no way to know if some clients are getting favored treatment or if brokers are putting their own interests first. The cases against ITG, UBS and other dark pool operators have underscored that idea. Defenders of dark pools have argued that their venues are in general safer from that kind of front-running, and that all investors benefit from competition that has driven down trading costs. The industry has also been opening up: One of its regulators now publishes ATS trading data each week and venue operators are providing customers with more information. As for the pools’ effect on markets, researchers are divided: While some say that price discovery doesn’t suffer from dark trading, others say that it does. SEC Chair Mary Jo White waded into the controversy in 2014, saying that consensus of research is that “the current extent of dark trading can sometimes detract from market quality.” The pools’ supporters say the NYSE’s offer to cut fees is proof of how much money the alternative trading systems have saved traders large and small. It’s possible the prospect of more regulation will steer the pools back to their original mission: Average trade size doubled in European pools even before new rules took effect.
The Reference Shelf
- The lawsuit brought by NY Attorney General Eric Schneiderman against Barclays.
- The U.S. Securities and Exchange Commission’s rule governing dark pools.
- The SEC’s list of registered Alternative Trading Systems, and its website on market structure.
- A Bloomberg BusinessWeek article on dark pools and off-exchange trading, and a chart shows the complex ways in which stock orders get filled .
- A CNBC article on “10 Things People Don’t Get About Dark Pools.”
- An excerpt in the New York Times Magazine from Michael Lewis’s 2014 book, “Flash Boys,” which suggests that dark pools have catered to high-speed traders.