A shot in the dark: an analysis of the SEC's response to the rise of dark pools.

• Author: Batista, Edwin

Introduction

The U.S. stock market has seen many dramatic changes since May 17, 1792, when twenty-four stockbrokers met outside of 68 Wall Street, New York under a buttonwood tree and started the New York Stock & Exchange Board. (1) Once a place ruled by humans, new advances in technology have transformed the stock market into a virtual no man's land where most traders are now aided by super computers and advanced trading software. (2) Advances in technology and new Securities and Exchange Commission ("SEC") rules allowing for greater access to the exchanges have given rise to high frequency trading ("HFT"). (3) HFT is a trading strategy that utilizes super computers to trade securities at high speeds and uses computer programs to quickly scan the market to locate and exploit pricing discrepancies. (4)

A major issue with HFT is that trades in the open market are subject to being front-run by the HFT computer programs. The front running occurs when these computer programs notice a pattern indicating an investor trade and, using their high speed trading ability, high-frequency traders will execute their own trade before the investor can complete his trade, thus making the investor's trade more expensive or less lucrative. (5) Investors looking for an escape from the HFT "predators" have found a shelter in dark pools. (6) Dark pools are segregated parts of the market offering anonymity, which traders use to avoid front running by high-frequency traders on public exchanges. (7) One of the most attractive reasons for trading in dark pools is that trades are not made public until they have been completed. (8) Currently, there are 50 dark pools in operation; the biggest one, Crossfinder, handles on average 132.5 million shares a day. (9)

Despite the advantages to traders, dark pools have been criticized for their lack of transparency, for creating a two-tiered market favoring larger investors over smaller investors, and for siphoning liquidity from other exchanges. (10) Despite these criticisms, dark pools were not a high priority concern for the SEC prior to the market collapse in 2008. (11) The market collapse and several events that cast doubts about the integrity of the market pushed HFT and dark pools to the top of the SEC's priority list. (12) Furthermore, new developments have shaken investor confidence in the markets and have made dark pools difficult to ignore, such as the 'Flash Crash' that occurred in 2010, the SEC fining the dark pool firm Pipeline Trading Systems $1 million to settle charges that brokers failed to disclose to customers that the majority of orders sent to the firm's dark pool were filled by a wholly owned trading affiliate in 2011, and a $440 million Knight Capital Group Inc. trading loss triggered by a software mal function that occurred in 2012. (13) In response to the market's outcry for actions against HFT and dark pools, the SEC released a set of proposals for regulating dark pools in November 2009. (14) Currently, the SEC is in the process of creating a consolidated audit trail ("CAT") and has approved rival "dark pools" to be run by the New York Stock Exchange ("NYSE"), the National Association of Securities Dealers Automated Quotations ("NASDAQ"), and the Better Alternative Trading System ("BATS"). (15)

In this note I will analyze the SEC's various responses to the issue of dark pools by discussing what they have done correctly, what they have done incorrectly, and I will present ideas for changes that the SEC has not proposed. (16) I argue that the SEC should take a mostly hands-off approach to dealing with dark pools and regulate them lightly. (17) Investors should have the option to use dark pools to avoid HFT. (18) I argue that requiring a CAT to be implemented is one of the most important actions the SEC has taken because it allows for efficient monitoring of dark pools and the market as a whole as well as facilitating quick responses after a significant market event such as a crash. (19) Furthermore, I believe the SEC made a good decision in allowing the NYSE, NASDAQ, and BATS to operate their own dark pools because it is providing another trading option for investors. (20) To achieve some meaningful changes to the market, the SEC should focus on controlling the predatory behavior by the HFT firms. (21)

Part I of this note will recount the history and discuss the purpose behind dark pools in the financial markets. (22) Part II will address the current events that have put dark pools in the SEC's cross hairs and highlight actions that the SEC has taken in response to the growth of dark pools. (23) In Part III, I will examine whether the SEC's proposals and actions are an effective way of dealing with the perceived growing threat of dark pools, and in Part IV I will present my conclusions. (24)

1. History

   Before the widespread use of computers in the stock market, trades occurred in arms length transactions on the floor of stock ex changes. (25) Buyers and sellers had to purchase seats and become market makers to trade on the exchanges, to which the investing public did not have access. (26) Market makers became the middlemen between investors and the exchange. (27) Market makers used their status as intermediaries to earn enormous profits from the difference between what they paid for a stock and the amount they charged investors for processing their trades. (28) This was the norm for many years, but the introduction of computers into the trading process caused massive changes to the system. (29)

   Although computers started being used for trading in the 1980s, market makers used the computers merely to increase the number of trades they could handle per day rather than to improve their clients' trading experience. (30) Electronic trading systems during this time had the capability to collect and distribute market data, allowing people that were using the same system to trade with one another and these systems had the capability to create a record of trading activity; however, these capabilities were rarely used outside of smaller exchanges. (31) Change came during the 1990s when the price of computer systems became more affordable and computer-based trading became mainstream. (32) Computer-based trading allowed investors to cut out the middlemen and match their own trades. (33)

   1. Rise of High-Frequency Trading

      Investors matched their own trades through the use of electronic communications networks ("ECNs"). (34) Entering the market in the 1990s, ECNs quickly matched buyers and sellers at their best price using advanced computer programs known as algorithms ("algos"). (35) The advantage of using ECNs was that it allowed for traders to remain anonymous, it facilitated quick trading, and it increased capacity for liquidity. (36) The use of the ECNs caused an emergence of new trading styles that relied on exploiting market inefficiency rather than traditional trading based on fundamentals and company growth prospects. (37) Eventually, traders and analysts started to get replaced with mathematicians and computer science experts who were more capable of running the complex algos than they were with making investment decisions. (38) Thus, HFT was born.

      High-frequency traders make money by either taking advantage of liquidity rebates offered by the exchanges or by profiting from individual trades. (39) The exchanges offered liquidity rebates to offset the price of ignorance. (40) The price of ignorance is the idea that although market makers have more information than the investing public, sophisticated traders, like hedge funds and fund managers, outmatch market makers, and therefore providing a market for these sophisticated investors is risky. (41) Market makers usually respond to this risk by widening their price quotes, meaning that when they offer to buy they do so at lower prices and conversely offer to sell at higher prices, and risk causes the difference between the buying price and selling price to be greater. (42) To promote market liquidity and stable prices, the exchanges offer traders maker-taker fees. (43) Maker-taker is a pricing system in which exchanges pay rebate fees to traders making bid-ask quotes and charge a fee to the clients that take the offer. (44) Although the amounts paid out by the maker-taker pricing system seem small, high-frequency traders are able to make a tidy profit by trading millions of shares a day. (45) High-frequency traders also make a profit from individual trades by exploiting the differences in prices between different venues. (46) High-frequency traders find trading opportunities by using their super computers to read incoming market order flow and by then front running investors' trades in fractions of a second. (47)

   2. Regulation National Market System and Alternative Trading System

      Institutional investors originally dealt with the issue of high-frequency traders front running their trades by not revealing the full extent of their trade until the last possible moment. (48) Investors would keep their trades secret by using block trading, in which investors would make arranged "secret" trades through a block trading desk and the trade details would appear only after the order was placed. (49) However, Regulation National Market System ("Reg. NMS"), (50) instituted in 2007, made this trading strategy significantly more difficult because it required national exchanges to collect and publish the quotations for the securities posted in their venues. (51) Reg. NMS forced all trading venues to monitor stock prices constantly on an electronic ticker tape called the Securities Information Processor, or SIP feed. (52)

      Furthermore, Reg. NMS mandated that any order to buy or sell had to go to the exchange with the best price. (53) This meant that HFT firms could trade through human-controlled markets such as the NYSE instead of trading exclusively on electronic exchanges. (54)

      Another convention that made it difficult for...