With Flash Eliminated, The Focus Now Shifts To Dark Pools

Now that Flash trading is practically a thing of the past, everyone's attention is shifting to dark pools. And if the just released letter by the World Federation of Exchanges is any indication, dark pools' days could be comparably numbered.

Dark pools are off-exchange trading venues, or Alternative Trading Systems (ATS) which are largely unregulated, allowing participants to transact in large blocks without disclosing trading intentions until long after the trade has been executed if at all. For the most part dark pools are run by investment banks themselves, with Goldman's Sigma X being a highly visible (pun intended) example, and one extensively discussed previously on Zero Hedge. The one prevailing characteristic of dark pools is the secrecy of transactions, revealed only to select transacting members. In their letter, the WFE warns that the "heightened opacity of these platforms in many countries inhibits price discovery and may lead to negative outcomes, including increased market volatility."

And while proponents of dark pools use the now all too generic explanation of enhanced liquidity, the question of whom this liquidity benefits is still an open one. The preliminary answer: only those who have access to such ATS venues benefit from the liquidity, which inherently is predominantly provided by the inventory of the ATS operator. As such it is merely a means of a firm like Goldman to offload proprietary positions to select clients.

Some notable concerns with dark pools stems from the very nature of the SEC's Regulation ATS "Fair Access Rules" which basically state that dark pools are non-democratic hierarchical organizations, with the ATS having veto power over who is allowed to trade on any given venue.

Probably the biggest complaint about dark pools has to do with the concept of actionable IOIs which are the practical (but not identical) equivalent of Flash orders on regulated exchanges. In an actionable IOI a firm seeking a bid or an offer will send out a ping to a subset of members, which never ends up in the public domain, and give the select dark pool participants a first and only look at whatever is about to hit the tape.

The WFE letter focuses on the same principles that Senator Kaufman has highlighted in his campaign for elimination of trading tiers and creating a level playing field.

There are two interconnected concerns of exchanges which merit the attention of G-20 leaders. First is the absence of a level playing field between exchanges and other entities performing some of the same or similar functions. Second is an erosion of price discovery arising from recent trends. As discussed below, these phenomena may be compromising the role of the public, regulated marketplace, and hampering exchanges' ability to fulfill their macroeconomic role.

And expanding on the loss of the level playing field:

In many jurisdictions, the introduction of alternative order execution platforms has led to significant internalization of order flow and related practices. These practices limit the visibility of orders, hampering investors' ability to respond to them and diluting the price discovery process. These practices also reduce the market participants' and regulators' ability, in many instances, to see overall market activity and may impact the conduct of proper market surveillance.

At the end of the day, all investors need to have confidence in the reliability of information reflected in the prices at which securities transactions occur. The heightened opacity of certain trading venues in many countries inhibits price discovery and may lead to negative outcomes, including increased market volatility.

The WFE Board believes that the current environment is creating an unequal distribution of the costs of providing a capital markets infrastructure at the expense of regulated markets and to the advantage of alternative trading venues. Regulated exchanges welcome competition, but it should not be structured in ways that can affect the quality of market operations and the soundness of the price discovery process. There have been new entrants with distinctive business models that have made significant contributions to our industry. The exchange industry is open to newcomers but it should be on a level playing field.

And the WFE's recommendation to the G-20 leaders:

The WFE Board recommends that the G-20 leaders consult with investor organizations about how they would wish to see orders executed in the markets, and determine whether alternative trading venues have reducing the total costs of transacting by investors.

The WFE Board also asks G20 leaders to assure a level playing field for the responsibilities assumed by all securities order execution venues. This would remedy many capital markets uncertainties. assuring greater transparency, greater fairness, and a more level competitive field.

The WFE points out that divergence even within the dark pool venue propagation, distinguishing between exchange operated and external dark pool operations.

Recently, some exchanges have accommodated these demands by creating order types or opening segments that allow trading that is not immediately visible to the rest of the market. In the case of exchanges, this trading is nonetheless tied into the visible market's surveillance and position-monitoring in order to assure the oversight of total market operations.

Other execution venues also offering dark trading in so-called "dark pools," but their trading and clients' positions are not visible for surveillance purposes. Regulators have no way to evaluate the risks which may be inherent in the combined on-exchange/off-exchange dark pool activities, nor what effects they might have on the visible markets.


Taken together, the combination of the absence of a level playing field between execution venues and decreased market transparency is an unsettling development. The policies and practices that exchanges have developed to ensure fair, orderly markets are at risk of becoming less meaningful and less available to investors and listed companies.

One could argue that here is where exchanges are hypocritical and one would be right. If the risk tolerance of an exchange operated dark pool if only mitigated by the fact that it is "regulated" by the SEC which is not only still trying to figure out what is going on 20 years ago, it would be remiss to state that the regulators will have any clue of any shady activity occurring on an exchange dark pool until it is far too late. Let's not forget that the SEC allowed Flash trading to exist only to seek to ban it several years later.

And while the pushback to the Flash ban has been relatively muted due to the lack of major market players who endorse it, the same can not be said of dark pools, which in effect positions two highly integrated and symbiotic players against each other. It would be amusing to watch the NYSE and Goldman Sachs, two integrated players in the market landscape, especially with the latter providing well over 20% of the NYSE open exchange liquidity via SLP, yet Goldman also dominating the dark pool arena via Sigma X. Is the trade off to the NYSE to antagonize Goldman, especially with Mr. Niederauer at the helm, a former Goldmanite, and potentially lose billions in exchange fees if it were to unwind the SLP monopolized by Goldman? Of course not. Which is why this push for yet another domino in the tiered market system to be toppled will have to come via regulatory and legislative intervention. Senators Kaufman and Schumer - the investing world is looking to you to continue your pursuit of a "level playing field" - your next step is the elimination of the entire dark pool concept.

Letter by the WFE to the G-20 presented below.