Regulators on two continents have noticed that too much trading in stocks takes place out of sight.
Tomorrow, European finance ministers plan to endorse legislation that would force transactions in privately owned venues known as dark pools into an organized trading system. Meanwhile in the U.S., the Financial Industry Regulatory Authority, the brokerage industry’s self-regulator, sent letters last month to 15 firms, seeking information on how they police their dark pools and what they disclose to customers.
The proliferation and growth of dark pools should concern anyone who buys or sells shares, not to mention workers whose retirement accounts hold stocks in mutual funds. Evidence is mounting that trading in dark pools increases the odds that buyers and sellers won’t easily find each other, so investors can lose out on the best possible prices.
The companies that own dark pools haven’t exactly made it easy to figure out what happens on their private trading systems: Credit Suisse Group AG, whose Crossfinder service is the biggest U.S. dark pool, in April stopped reporting the number of transactions it processes. About a dozen other dark pools already keep mum about their trading, and there is nothing to stop the rest from joining the silence. This would further obscure the transparency that has helped make American capital markets the most appealing in the world.
Dark pools arose in the 1980s when the Securities and Exchange Commission said brokers could bring together buyers and sellers to trade anonymously. Rather than routing customer orders to the traditional exchanges, brokers could send them to an outside trading service or execute orders on their own internal systems, pocketing the spreads on prices and trading fees. Today, as much as 40 percent of trading in U.S. equities takes place away from the public stock exchanges.
Explosive Growth
Not surprisingly, trading on dark pools and brokers’ internal trading systems has exploded in recent years. Most of the increase has come at the expense of U.S. stock exchanges, where volume has fallen more than 30 percent in the past three years, according to data compiled by Bloomberg. There even are signs that dark pools are picking up the business of small investors, based on research that shows the average dark-pool transaction involves just 200 shares.
To their credit, dark pools have forced the stock exchanges to be more competitive through technological innovation. But the growth of dark pools also reflects the higher operating and compliance costs of their heavily regulated exchange rivals, an obvious benefit for firms such as Goldman Sachs Group Inc., UBS AG and Barclays Plc, which own three of the five largest private trading services.
All this fragmentation means that buyers and sellers aren’t meeting in a central location where information is shared, endangering the price-discovery function on which efficient markets depend.
The SEC, however, doesn’t have the authority to oversee dark pools the way it does exchanges, which have public-utility- like obligations. Exchanges match supply and demand, make buy and sell quotes publicly available, post trading prices, and police their markets for fraud and insider trading.