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Danger in the Water: Regulators Turning Attention to Dark Pools

Author: Dan Brecher|July 17, 2015

Securities regulators are increasingly turning their attention to dark pools, which are far less regulated than traditional exchanges. The European Union’s (EU) new rules will take effect in 2017, and the Securities and Exchange Commission (SEC) proposed its own rules earlier this year.

Danger in the Water: Regulators Turning Attention to Dark Pools

Securities regulators are increasingly turning their attention to dark pools, which are far less regulated than traditional exchanges. The European Union’s (EU) new rules will take effect in 2017, and the Securities and Exchange Commission (SEC) proposed its own rules earlier this year.

Dark pools are private, alternative trading systems (ATS) in which participants can transact their trades without displaying pre-trade prices and trade volume to the public. According to Bloomberg, securities traded in private venues such as dark pools can account for up to 40 percent of total share volume on any given day. When the New York Stock Exchange recently suffered a software glitch that forced it to shut down, trading continued via dark pools.

Under the EU’s new securities rules, trading systems will be required to disclose pre-trade bid and offer prices as well as trading volumes. The regulation exempts platforms dealing with “large in scale” transactions; however, the specific threshold has yet to be established.

Proposed regulations

The SEC’s proposed regulations would require high-frequency trading firms to register with the Financial Industry Regulatory Authority (FINRA). Many firms currently rely on SEC Rule 15b9-1, which exempts certain brokers-dealers from membership in a national securities association if they are a member of a national securities exchange, carry no customer accounts, and have annual gross income of no more than $1,000 that is derived from securities transactions affected otherwise than on a national securities exchange of which they are a member. Income derived from proprietary trading conducted with or through another broker-dealer does not count against the $1,000 limit.

In support of its proposed amendments to the rule, the SEC cites that the exemption is no longer being used as originally intended, which was to “accommodate exchange specialists and other floor members that might need to conduct limited hedging or other off-exchange activities ancillary to their floor-based business.” During 2012, 2013 and 2014, non-FINRA members accounted for 32 percent, 40 percent, and 48 percent, respectively, of orders sent directly to ATSs. While the rule would not prohibit trading in dark pools, it would help FINRA and the SEC capture more data about the transactions.

Issues with dark pools

While many institutional investors prefer dark pools, regulators are fearful that the lack of transparency makes them more susceptible to conflicts of interest and unscrupulous traders. Earlier this year, UBS paid $14 million to resolve SEC charges that it secretly created an order type for its dark pool that gave preference to high-frequency traders over other customers.

On the local level, New York Attorney General Eric Schneiderman filed suit against Barclays Capital Inc. last year, alleging that Barclays operated its dark pool to favor high frequency traders despite public statements that assured otherwise; favored its own dark pool when routing client orders to trading venues; and misrepresented its “Liquidity Profiling” service, which was intended to identify predatory traders. “Barclays grew its dark pool by telling investors they were diving into safe waters,” Schneiderman said in a press statement announcing the suit. “Barclays’ dark pool was full of predators – there at Barclays’ invitation.”

Danger in the Water: Regulators Turning Attention to Dark Pools

Author: Dan Brecher

Dark pools are private, alternative trading systems (ATS) in which participants can transact their trades without displaying pre-trade prices and trade volume to the public. According to Bloomberg, securities traded in private venues such as dark pools can account for up to 40 percent of total share volume on any given day. When the New York Stock Exchange recently suffered a software glitch that forced it to shut down, trading continued via dark pools.

Under the EU’s new securities rules, trading systems will be required to disclose pre-trade bid and offer prices as well as trading volumes. The regulation exempts platforms dealing with “large in scale” transactions; however, the specific threshold has yet to be established.

Proposed regulations

The SEC’s proposed regulations would require high-frequency trading firms to register with the Financial Industry Regulatory Authority (FINRA). Many firms currently rely on SEC Rule 15b9-1, which exempts certain brokers-dealers from membership in a national securities association if they are a member of a national securities exchange, carry no customer accounts, and have annual gross income of no more than $1,000 that is derived from securities transactions affected otherwise than on a national securities exchange of which they are a member. Income derived from proprietary trading conducted with or through another broker-dealer does not count against the $1,000 limit.

In support of its proposed amendments to the rule, the SEC cites that the exemption is no longer being used as originally intended, which was to “accommodate exchange specialists and other floor members that might need to conduct limited hedging or other off-exchange activities ancillary to their floor-based business.” During 2012, 2013 and 2014, non-FINRA members accounted for 32 percent, 40 percent, and 48 percent, respectively, of orders sent directly to ATSs. While the rule would not prohibit trading in dark pools, it would help FINRA and the SEC capture more data about the transactions.

Issues with dark pools

While many institutional investors prefer dark pools, regulators are fearful that the lack of transparency makes them more susceptible to conflicts of interest and unscrupulous traders. Earlier this year, UBS paid $14 million to resolve SEC charges that it secretly created an order type for its dark pool that gave preference to high-frequency traders over other customers.

On the local level, New York Attorney General Eric Schneiderman filed suit against Barclays Capital Inc. last year, alleging that Barclays operated its dark pool to favor high frequency traders despite public statements that assured otherwise; favored its own dark pool when routing client orders to trading venues; and misrepresented its “Liquidity Profiling” service, which was intended to identify predatory traders. “Barclays grew its dark pool by telling investors they were diving into safe waters,” Schneiderman said in a press statement announcing the suit. “Barclays’ dark pool was full of predators – there at Barclays’ invitation.”

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