The Dark Side of the Pools (Part 2)
Dark pools are not regulated exchanges but are regulated under Regulation ATS. Regulation ATS was adopted in 1998, well before the degree of fragmentation that has occurred in the markets. As a result, the Regulation was not designed to address many of the problems that have arisen in an era of for profit exchanges, high frequency trader, and a market with 50 or more trading centers.
Dark pools provide trading centers that do not disclose the "identity of counterparties or display specific order information." The lack of transparency, therefore, has its advantages. It also, however, had disadvantages. As the Report from Health Markets notes, dark pools confront a common competitive concern.
- Increasing their fill rates and executions meant that dark pools had to find counterparties for their resting orders. This task has always been a significant challenge. Simply stated, it is relatively rare that at the exact same time one mutual fund complex wishes to sell one million shares of a particular stock, another institution in the pool will just happen to want the same million shares. Of course, from a trader’s perspective, the longer an order rests in a dark pool, the greater the risk of information leakage and increased opportunity costs.
One way to accomplish this task is to allow high frequency traders into the pool. The Dark Pools are not, therefore, a collection of like minded institutions looking to make block trades. Instead, trading patters began to resemble those in the lit markets. See Healthy Markets Report at 9 ("As high-speed traders entered the pools, trading volumes sky-rocketed, but the characteristics of dark pools changed. Execution sizes came down, . . . ultimately converging at the same value as on lit markets.").
In assessing the quality of trades in Dark Pools, institutions can try to engage in self help. This, according to the Healthy Markets Report, is not easy or, in some cases, possible.
- One reason is that most investors lack comprehensive market data against which to compare their trading. In recent months, some firms have sought to quickly fill this need through enhanced analyses by comparing their customers’ information against public market information about executions. Detailed trading analyses are important, but they are also subject to the quality and breadth of information provided, as well as to the technical expertise, biases, and analytical capabilities of providers.
- These analyses will also take time to complete, and once completed, will likely provide little illumination. Of course, if a venue is shown to perform extremely poorly, then an investor or broker should immediately suspend trading at that venue, and route elsewhere. But if the analysis was already clear-cut enough to make this determination, we suspect that such poor performance would have already been identified and order flow to that venue curtailed.
So, other than the abandonment of Dark Pools, what can be done?