While “The Big Short” is generating Oscar buzz in Hollywood, it is “Flash Boys,” Michael Lewis’s most recent book, that is generating talk among financial regulators. “Flash Boys” tells of the rise of high-frequency trading (“HFT”) and alternative trading systems (“ATSs”), including so-called “dark pools,” where an increasingly-high volume of equity trading is carried out behind a veil of secrecy. Now, the Securities and Exchange Commission (“SEC”) has set its sights on regulating ATSs, considering rules that would require dark pools to publicly disclose details on how they work, who their customers are, and what steps they take to safeguard confidential trading information.
By way of background, dark pools are private stock exchanges with very limited transparency. The average investor has no access to, or real-time visibility into, dark pools. Rather, dark pool investors keep the size of their orders and their identity hidden from the public market, with the hope of reducing trading costs. The prices of orders entered into the dark pool are not displayed to market participants and are theoretically matched anonymously. As one commentator has noted, dark pool investors “pay to trade in the dark, where other people can’t watch them, trade with them, or intervene.” Given this structure, it is little surprise that dark pools have emerged primarily to facilitate block trading, which is the practice of trading a large number of shares outside of the open markets in order to avoid affecting the public prices.
While dark pools have existed in some form for decades, their popularity has spiked in recent years. Some estimate that dark pool volume accounts for about 30% of all U.S. equity volume, and that a significant portion of that volume is short sellers. Last year, European dark pools saw a 45% increase in trading, far above the 28% growth for public exchanges.
Given the lack of transparency, and increasing trading volume, dark pools are ripe for abuse. The broker-dealers that run dark pools have faced intense scrutiny recently concerning conflicts of interest with their investor clients. Dark pools, just like any other exchange, must have liquidity in order to operate. Traders need to find counterparties, quickly and consistently. To accomplish this, dark pools have taken a number of steps, including: allowing their own propriety trading desks (or their affiliates) access to their dark pools; and/or providing high-frequency traders with access to their pools. Both practices can pose problems for investors. Propriety trading must be clearly disclosed and investors must be assured that the trading desks do not enjoy an unjust competitive edge over other dark pool investors. Further, dark pool policies must ensure investors that their information and trading is kept confidential, and that dark pool insiders are not using that information to gain an unfair advantage. Similarly, investors need to know if HFTs are being provided any special access to the pools that would allow them to exploit the exchange by front-running trades.
Regulators are increasingly investigating such practices. For example, a New York brokerage firm, Investment Technology Group, agreed to pay the SEC $20.3 million and admitted that it had established an internal trading desk that used and traded off its dark pool customers’ information without telling them. UBS Securities LLC agreed to pay a $14.4 million penalty to settle claims by the SEC that the firm violated the “Sub-Penny Rule” by allowing certain users of its dark pools to place sub penny priced orders that jumped ahead of other orders submitted at legal, whole-penny prices. Goldman Sachs was fined $800,000 by the Financial Industry Regulatory Authority (“FINRA”) for failing to prevent trade-throughs – a practice where orders are executed at a non-optimal price where a better price is available on the same or different exchange. Moreover, it has also been reported that Barclays will pay $65 million to the SEC and the New York Attorney General to settle claims that it failed to inform its clients that Barclays’ own HFT desks traded in the dark pool. Credit Suisse, which operates one of the largest dark pools, also reportedly has agree to pay $85 million to settle claims by the SEC and the New York Attorney General accusing the bank of not providing enough disclosures to clients about how its dark pool operates.
In addition to these enforcement actions, the SEC announced in November that it is drafting regulations intended to shed more light on dark pools and other ATSs. The SEC has proposed rules aimed at enhancing transparency and oversight of ATSs. The proposed rules will require the broker-dealers that sponsor dark pools to disclose to the markets whether they have agreements to route trades to certain unaffiliated venues and whether the broker-dealer has trading positions within the dark pool. The proposal also calls for dark pool operators to make disclosures about how they are safeguarding their clients’ confidential information. A final rule could be expected later this year, but the hope is that any new rules will increase transparency for investors and ensure that they are not being taken advantage of in the darker corners of dark pools.