Following the financial crisis, the Securities and Exchange Commission has redoubled efforts to shine a light on opaque practices that deny investors fair access to information and potentially could damage the integrity of the national market system. But industry participants are concerned that a recent proposal actually will make matters worse.
An SEC proposal for increasing transparency into dark liquidity pools has sparked debate in the industry over whether disclosure of trades on a real-time basis could play into the strategies of gamers and high-frequency traders. In October 2009 the SEC issued a concept release detailing rules that would require real-time disclosure of the identity of dark pools and other alternative trading systems (ATSs) on the reports of their respective executed trades. The proposal would mandate that dark pools and ATSs attain specific market participant identifiers (MPIDs).
Currently, dark pools, which are members of the Financial Industry Regulatory Authority (FINRA), report their trades to a trade reporting facility, or TRF, operated by either NYSE Euronext or Nasdaq, or to FINRA's Alternative Display Facility (ADF). But these trades are identified as over-the-counter trades, so the identify of the dark pool that executed the trade is not publically disclosed.
While no rules have been finalized, SEC proposals for the regulation of dark pools -- termed "non-public trading interest" -- were made available for public comment until February 22, 2010. The commission could impose new requirements to promote visibility into the private equity trading networks.
"The large institutional firms can see an awful lot of risk if there is real-time disclosure," comments Bernard Donefer, distinguished lecturer, associate director, Subotnick Financial Services Center at Baruch College. "One of the things that institutions are afraid of is that, if dark pools are forced to report in real-time, people can look at those little footprints on the ticker and say, 'There is somebody doing big trades in this stock,' and use that to game the system," he explains. "These are quant strategies looking at trading patterns for anomalies to take advantage of market impact, and not necessarily evil people."
The proposal is somewhat of a Catch-22. While traditional asset managers would like more data on which stocks are trading in dark pools, they are reluctant to leave a trail of bread crumbs for high-frequency traders to pick up. "There's too much leakage, and it doesn't benefit anyone other than high-frequency trading shops," comments Andrew Weinberg, global equity trader at PineBridge Investments in Dallas.
If the high-frequency trading shops see that a particular stock traded in a dark pool, Weinberg warns, the information could be used against the buy side. "It's probably giving too much data for them to know which dark pools to go into, and for the lack of a better word, to 'game' the liquidity," he suggests, noting that since HFT firms are using the fastest technology, they can get to the venues first and take advantage of the information. "Whereas long-only asset managers and mutual funds are looking for the best source of liquidity and for minimal impact, if you start announcing which dark pools have liquidity, there's an opportunity for fast money to game against them."
The SEC realizes, however, that disclosing the identity of ATSs could cause information leakage that would be damaging to institutions executing large block trades. Hence, the agency's proposal would protect the identity of an ATS executing a large trade with a market value of at least $200,000.
But while the SEC is prepared to make an exception for block trades, Weinberg argues that the identification of ATSs that execute smaller trades is even more of a concern. "The danger is more in the smaller pieces -- that's where you are going to see the high-frequency [traders]," he asserts. Instead of looking at the 30,000- to 40,000-share trades, HFT firms, which rapidly buy and sell shares to capture arbitrage opportunities, are more interested in the 300-share prints, Weinberg suggests.
Since the HFT strategies monitor how stocks "are reacting and behaving, imagine giving them more information about where the liquidity is," Weinberg continues. "That's going to make it even easier for them to hit one destination as opposed to hitting all the others."
Brokers that operate dark pools also are concerned that disclosing trades in real-time with a unique identifier could provide gamers with an edge. In a letter commenting on the SEC's proposals, ITG, an agency broker that develops algorithmic trading strategies and operates the ITG Posit dark pool, expressed concern that including the identify of an ATS on its trade reports on a real-time basis may allow traders to take advantage of large orders being executed on an ATS. "ITG supports disclosing the identity of the ATS on the reports of executed trades. However, we believe that such disclosure should be done on a delayed basis, such as the end of the trading day," the company stated.
"We're against the real-time stock-by-stock disclosure. "We feel that it is too much information that can be taken advantage of by gamers," comments Dmitri Galinov, director of Credit Suisse Advanced Execution Services (AES), which operates CrossFinder ATS, the largest U.S. equity dark pool, according to Rosenblatt Securities reports.
"Basically, disclosing real-time stock-by-stock trades is going to bring more harm than good," says Galinov, noting this would be especially the case with small cap stocks. If Crossfinder is printing trades for a particular small cap stock, he explains, "The gamers will know the dark pool has a significant representation [for that stock] from institutional customers."
Closing the Information Gap
Some buy-side traders, however, are not comfortable with the current lack of information about where trading in dark pools takes place. "It's still a mystery," says Jeff Albright, head trader at Waddell & Reed Asset Management in Shawnee Mission, Kan. "Quite frankly, I believe if we're representing an institution as an active participant, we should be able to see where the volume is trading after the fact, just as a regular trade is reported outside of the dark."
While Albright says he's not sure if the dark pool trades need to be reported to the tape in real time, he doesn't see why a dark pool shouldn't be forced to play by the same rules as the lit markets. Currently, all dark pools must report their trades within 90 seconds to the TRF operated by either NYSE Euronext or by Nasdaq or to FINRA's ADF. Market centers (i.e., exchanges) are required to report their trade activity within 90 seconds to the Consolidated Trade System (CTS), but unlike dark pools, regulated exchanges are required to publish the name of the venue on which the trade took place.
Experts point out, however, that dark pool and ATS executions are reported as OTC trades in the consolidated tape. "When you look at a TRF or the ADF, it just indicates the trade was done OTC," explains Baruch's Donefer. "You don't know if that was an upstairs trade done at Goldman Sachs or at a dark pool. You don't know if that was done by a market maker or OTC at an exchange."
In its concept release, the SEC contended that the current level of post-trade transparency for ATSs is inadequate. Though these trades are reported to the tape using the broker's MPID, it's not clear whether the trades were executed in the broker's dark pool or via its market maker desk. As a result, the dark pool volumes are lumped in with the broker-dealer's internalized volumes, say industry sources.