The Security and Exchange Commission (SEC) in the United States (the main securities market regulator) is in the process of tightening the regulations surrounding the operations of “dark pools” which should be finalized in a matter of months.

Tighter regulations are being implemented regularly in the financial markets, and are usually implemented in response to an identified weakness. 

What are Dark Pools, and Why are they the Next Target?

Dark pools are used by institutions as a way to trade without valuable trading information being leaked to other investors who would look to “copy” their trading strategies.

They are regularly used by institutions such as hedge funds that buy and sell high volumes of assets daily for anonymity in the market.

Despite them being used by firms since the 1980s, regulators have been becoming increasingly concerned about their opaque nature.

Why are Dark Pools Considered Detrimental to Financial Markets?

To begin understanding the reasons why dark pools could be detrimental to financial markets, its necessary the reason why dark pools were created in the first place. 

Historically, all requests for orders in equity markets were advertised in real time which was meant to attract further liquidity for an efficient market.

One of the outcomes of a completely open and clear market is that the demand for an asset relative to its supply can be quickly determined, and the price is reflected accordingly to reach equilibrium.

If you are a financial institution with a large quantity of a single stock which you no longer deem good value, you would look to sell that on the open market.

Without a dark pool, you are likely to:

• Reduce the value of the asset by increasing its supply in the market (limiting the potential total liquidation value)
• Signal your intent to sell which can also indicate to other investors that they should sell too, further reducing the value of the asset.

The same can be said for a firm looking to increase their holdings of a single stock (where prices can increase due to increased demand, and reduced market supply).

While selling large quantities of a stock is still likely to reduce the value of an asset, the dark pool can help an institution looking to hide its intentions, providing liquidity without the large market impact.

Despite the positives associated with dark pools, there are also a number of negatives.

The first issue is “fishing” by investors who can deduce the rules of a dark pool using a test order, and then uses those rules to game the system to their advantage.

A simple example of this practice would be to place a small sell order of 100 shares of an illiquid stock (small cap, or something similar with low liquidity).

If the order is met quickly, then the investor could assume that there is a significant buy order in a dark pool.

They could then place a large buy order in the market to compete with the dark pool (increasing the demand and the price), and then simultaneously put a sell order of a very large amount (e.g. 10,000 shares) to make a profit from the new inflated price.

Additionally, the existence of information asymmetry about market liquidity can lead to traders losing out due to the price not reflecting the liquidity of the market.

An example of this situation is that a trader would like to sell 100,000 shares in the market using the dark pool.

Another trader who has placed a buy order for 10,000 shares unaware that there is a significant supply in the market has their order executed.

As dark pools have a limit to the amount of hidden liquidity that they can provide, the first trader then decides to take the remaining 90,000 shares, and distribute it to visible markets where the price is lowered from the increased, visible supply, reducing the value of the shares that the other trader purchased.

There are many types of dark pool set up in order to realize the benefits listed above, such as independent crossing networks (ICN), broker-dealer internalization pools, exchange operated pools, consortium owned pools and ping destinations, but I won’t go into the intricacies of each for this overview.

What are the Regulations Trying to Achieve?

The aim of regulations really focus on the ability for investors to perform High Frequency Trading (HFT) to generate profits from price inefficiencies in incredibly short spaces of time using highly sophisticated computer models.

Furthermore, High Frequency Traders can get a sneak peek at the prices of assets which are to be routed onto the visible market after the dark pool liquidity is used up, allowing them to get an unfair advantage over traditional investors without access to similar computer systems.

Even before the SECs latest proposals for dark pool regulation were discussed, the International Organization of Securities Commissions (IOSCO) released its “Principles for Dark Liquidity” in 2011.

They looked to achieve the following goals:

• Minimize the adverse impact of the increase use of dark pools and dark orders in transparent markets on the price discovery process by generally promoting pre-trade and post-trade transparency and encouraging the priority of transparent orders,
• Mitigate the effect of any potential fragmentation of information and liquidity by generally promoting pre-trade and post-trade transparency and consolidation of such information,
• Help to ensure that regulators have access to adequate information to monitor the use of dark pools and dark orders for market monitoring / surveillance purposes and to enable an appropriate regulatory response to market developments,
• Help ensure that market participants have sufficient information so that they are able to understand the manner in which orders will be handled and executed.

As dark pools have been gaining market share on the traditional stock exchanges, it is understandable that regulators have been looking to minimize their impact on traditional markets.

Where dark pools potentially were small players in the market, the impact from the information asymmetry was somewhat limited, but as their prominence and market share increases, you can expect far more regulatory pressure and scrutiny in the future.