The Cost Of Dark Pool Transparency

(Dow Jones) While mutual-fund companies are reticent about just how much trading they're doing in dark pools, they clearly have a large stake in these anonymous venues. And proposals to make trading more transparent could increase their costs.

Historically, mutual funds worked with brokers to place large block orders, which permitted them to remain anonymous and to cloak the size of their orders from the marketplace in order to prevent front-running. Today's dark pools automate that facility, offering the same advantages at a far cheaper cost, said Gus Sauter, chief investment officer at the Vanguard Group.

The pools are considered "dark" because trading interest in stocks expressed on them isn't included in consolidated quotation data that's widely disseminated to the public. For institutional investors like mutual funds, the pools are a valuable tool to conceal their order flow from traders who seek to take advantage, said Kevin Cronin, managing director and head of global head of equity trading at Invesco Ltd.

Changes proposed by the Securities and Exchange Commission would increase the transparency of the pools. The SEC is accepting comments through February 22.

The Investment Company Institute, the mutual fund trade group, has urged policymakers to take a measured approach and be wary of unintended consequences.

"Mutual funds are significant users of these trading venues," it said in an October 28 statement to a subcommittee of the Senate Committee on Banking, Housing & Urban Affairs. It declined further comment.

The SEC has proposed that actionable indications of interest, or IOIs-which are similar to buy or sell quotes-offered on dark pools be subject to the same disclosure rules as other quotes.

Under the SEC's proposal, however, actionable IOIs for a quantity of stock with a market value of at least $200,000 would be excluded from the disclosure rules in some cases. The ICI's statement noted that the SEC would preserve the ability of mutual funds to trade large blocks of securities by allowing certain large orders to remain "dark."

"We must consider, however, whether additional steps must be taken by policymakers to address other ways that mutual funds trade, for example, when funds break up large orders into smaller pieces that are executed separately," the ICI said in its October 28 statement.

Because of the market's structure, Sauter explained, large block orders are often executed in pieces. "If you go out to buy 50,000 shares of Microsoft, that could literally be 100 or 200 trades," he said. There may be ways to ensure that large orders are kept anonymous even when executed in pieces, he said.

Invesco's Cronin said the SEC is trying to strike the right balance with its proposal. "I'm comforted by the fact that there is a limitation on what needs to be divulged," he said.

The SEC has also proposed substantially lowering the level of trading volume in a particular security in each pool that triggers the public dissemination of best-priced orders for a listed stock, and requiring that the identity of dark pools be disclosed publicly on reports of executed trades.

If the volume trigger is lowered and a particular security hits that level on a specific pool, it "certainly changes the nature of that dark pool for that particular security," said Sauter. "It no longer has the features that a block trader would be looking for."

Cronin said that reporting the identity of pools on reports of an executed trade is concerning. Doing so could permit an entrepreneurial trader to "not only determine if there are large buy or sell orders, but do the math to figure out the order size and how it's being carved up over the course of the day." The trader could then start buying in front of large orders, Cronin said.

Vanguard's Sauter, however, said traders have that capability already; the change would just make it easier for them.