Does an unregulated and shadowy market, laden with systemic risk and vulnerable to counterparty default, sound familiar?  It may, drawing on the waves of debacle that crashed down on the financial system in the fall of 2008.  While regulatory minds remain focused on secretive hedge funds and under-regulated credit default swaps (CDS), they should be thinking about another such area too: “dark pools.”  When a financial market involving all major institutions has as its principal selling point its lack of transparency and regulation, legal and regulatory antenna should start buzzing.

As background, dark pools are exploding in popularity with their two newest, or soon to be, high flyers: NYSE’s New York Block Exchange (NYBX) and the London Stock Exchanges’ (LSE) Baikal, which is slated to open later this year. The reason for this popularity is that they are anonymity-promising exchanges, mediated by broker-dealers. Technically, “dark pools” are markets that match block orders (orders greater than 10,000 shares or $200,000 in value).  Also called electronic crossing networks (ECN) and alternative trading systems (ATS), they allow investors to anonymously buy and sell large amounts of stock without moving the market price. Hopefully, the darkness also allows the investors’ trades to go through without the hindrances of “front-running” brokers and “back-dooring” speculators. 

While these dark pools are a new development, the needs driving them are not. Institutional investors have long dealt with this issue by simply breaking huge block orders up into streams of smaller trades.  What is new (apart from their rapid growth and sheer size) is the unregulated nature of these markets, their infrastructure (or lack thereof), the fiduciary duties they may complicate, and the business impact they have on participants. 

Lack of regulation is a great concern. The sense of déjà vu is most likely from the Lehman Brothers and AIG CDS debacles last year. A default of a large market participant could roil markets once again.  This is no small matter, as dark pools are run by big players like Credit Suisse’s Crossfinder and Liquidnet, which average 160 million and 17 billion shares traded per day. The Bank of New York Mellon also runs a large dark pool called ConvergEx Group. Yet the danger is even greater than that: there are financial institutions that both operate and trade on dark pools.  The impact of any one of them defaulting could risk both the trading venue and the trades (and counterparties) themselves.  With other bank controlled dark pools including UBS’ Price Improvement Network (PIN ATN), Goldman Sachs’ SigmaX, and JP Morgan’s Lighthouse, this is no small question. 

Dark pools have not completely escaped the notice of regulators though. In the U.S. the SEC has so far taken a hands-off approach on dark pools, though it has stated that it believes has the authority to regulate the pools if it is deemed necessary. That said, despite talking about the dark pools quite often, and focusing on the esoteric topic of price discovery as often as possible, the SEC has not decided to take any action. This hands-off approach may change as major exchanges start operations and traders increasingly head for the cover of darkness.  In the United Kingdom, the Financial Services Authority (FSA) has launched an inquiry into the mechanics of dark pools, particularly their impact on the stages leading up to a trade, including the publication of prices. The European Commission's directive on markets in financial instruments main goals was to increase transparency and create a level playing field between institutional and retail investors. Could the U.S., home of many mutual fund market timing scandals and Regulation Fair Disclosure, be that far behind? Also, there are issues of how fair hedge playing in the dark pools. “Gaming” is basically the process of buying small lots of small capitalization stocks and then selling them for more through dark pools. Gaming is undoubtedly a form of market manipulation, but the practice is allegedly running rife in the market today. Dark Pools also supposedly help foster the more pedestrian market no-no of naked shorting. It remains to be seen how regulators will deal with dark pools as they become more mainstream.

Lack of infrastructure is another concerning issue in these markets. Unlike other more regulated exchanges, dark pools lack a central counterparty (CCP) standing between trades.  A CCP is an entity that stands in the middle of each transaction (i.e., it buys stock from the seller and sells the stock to the buyer) and assumes all the counterparty risk.  Rather, they are broker mediated, opaque and laden with counterparty-risk.

Fiduciary duties arise around these dark pools as some of their largest participants are mutual funds.  These funds typically own big share blocks but don’t want to move markets with their trades – hence their reliance on ATS. However, funds have a fiduciary duty to ensure that transactions are conducted in line with best execution policies (i.e., for the benefit of the funds shareholders and not those of management and the brokers). Just this week, the SEC announced that several financial firms, including specialists related to marquee firms like Goldman Sachs and Susquehanna, would pay $70 million for violating their basic obligation as specialists to serve public customer orders over their own proprietary interests. Basically, the banks’ specialists were allowing the banks’ traders to front-run customer orders. If the banks are willing to do this on open exchanges, then what could they do in a dark pool (especially if it is the bank’s own dark pool). Major institutional investors like Blackrock, SPDR, and Franklin Templeton all using these dark pools to execute trades, when the price is right. But how can the funds or regulators police this sort of self-dealing in opaque dark pools?

Finally, competitive risks emerge around any new business and this one is no exception. Though they’re code-named “dark pools”, the public and the SEC are not at all in-the-dark about them as there are public disclosures on some of the pools.  Among them: there are pure-play companies that operate dark pools, banks that own and operate in pools, and traditional exchanges that compete with dark pools. Further, this is an extremely competitive space, leading to yet other disclosures. Publicly traded dark pools such as Liquidnet and Investment Technology Group (both are large pure-play dark pool operators) have disclosed risk arising from increased competition throughout the dark pool market. More traditional exchanges and execution service providers like the Chicago Mercantile Exchange (CME), Knight Capital Group, and Piper Jaffray have all mentioned the risks to their business models arising from the advent of dark pools. With the market growing so quickly one has to wonder what happens if dark pools begin to cloud the price discovery function of normal stock markets? The SEC has made plenty of comments about the potential price discovery problems, or lack thereof, posed by dark pools.

Recent events have shown that lightly regulated markets are seen by investors as an invitation for fraud and abuse. Will the growth of dark pools affect corporate governance issues and even the underlying transactions (M&A, buybacks, and other corporate decisions) that grease the wheels of a nation’s industry? Could the new administration let another unregulated and opaque market grow right under its nose? For now, the answer seems to be yes. The real question is whether or not it will allow the market to metastasize into a mountain of systemic risk the way the CDS market did. Lehman Brothers ran a dark pool, but due to its small size and the fact that the market had much more glaring issues to deal with, like mortgage-backed securities and CDS, its dark pool went virtually unnoticed. Will that be case if dark pools continue on their current growth trajectory without any regulatory guidance?  One issue for the new SEC will be striking the right balance between the value that a dark pool’s anonymity creates and the broader need of properly functioning capital markets for transparency.

Published: March 5, 2009