{Bloomberg) — Whether they like it or not, banks are opening up their dark pools, the private venues that host 17 percent of trading in the $24 trillion U.S. stock market.
Off-exchange markets accounting for more than 40 percent of dark-pool volume have publicly disclosed rules of operation that were previously hidden. Theyre taking the step amid New York Attorney General Eric Schneidermans accusation that Barclays Plc misled clients about the presence of high-frequency traders in its private stock market.
Banks and brokers that own the markets are finding it harder to maintain the cloak of secrecy that used to define the venues. Schneiderman is scrutinizing the biggest dark pools, according to a person familiar with the matter, while the U.S. Securities and Exchange Commission is probing the industry. The Financial Industry Regulatory Authoritys board meets this week to decide whether to make private venues give it more data.
Reacting to the controversy, customers are demanding more information about how orders are processed, according to John Cosenza, co-head of electronic trading at Cowen & Co., a New York-based brokerage.
We have witnessed a material rise in the amount of requests, Cosenza, whose firm doesnt operate a private venue, wrote in an e-mail. The demand for greater transparency in the industry doesnt seem to be slowing down.
(Bloomberg LP, the parent of Bloomberg News, owns a stake in Bids Trading LP, which operates a dark pool.)
The 1980s
Dark pools evolved from off-exchange platforms that institutions and professional investors set up in the 1980s as an alternative to public markets. Banks, including Goldman Sachs Group Inc., UBS AG and Credit Suisse Group AG, created the venues partly to avoid paying stock exchanges for processing trades between the banks clients.
The industry emphasized the platforms secrecy as a benefit. Dark pools helped investors hide large transactions from traders who might profit from changing prices. Critics allege that the banks secretly encouraged high-speed brokers to use their dark pools, exposing other investors to predatory behavior.
Michael Lewiss book Flash Boys, published in March, alleged high-frequency traders used the private venues to make money from slower investors. Dark pools accounted for 16.5 percent of all U.S. stock trading in the first eight months of the year, according to data from Rosenblatt Securities Inc.
Toxic Traders
In June, New York states Schneiderman accused Barclays of lying to its customers when it claimed to protect them from aggressive, predatory or toxic traders. Trading volume on Barclays venue has shrunk to one-quarter of what it was before the complaint, according to Finra data.
Finra, which began publishing data on private venues in June, will discuss additional ways to make off-exchange trading more transparent at a board meeting on Sept. 19. These include compelling alternative trading platforms to disclose more information about their order books and expanding the data it publishes about the volume of over-the-counter trading by stock.
In addition to his probe into Barclays, Schneiderman is investigating dark pools run by Credit Suisse, Deutsche Bank AG, Goldman Sachs, Morgan Stanley and UBS, according to a person familiar with the matter, who asked to not be named because the review is private.
The SEC is also examining private venues. In a speech this year, Chair Mary Jo White said shed asked the agency to look at ways to increase transparency around alternative trading systems.
Public Information
I also have asked the SEC staff to prepare a recommendation to the Commission to expand the information about ATS operations submitted to us and to make the information available to the public, White said, according to a transcript on the SECs website.
Some banks have responded to increased scrutiny by publishing their dark pools Form ATS, a file that describes how the venue works. In the past, theyd refrained from releasing the documents, which are filed confidentially with the SEC. Credit Suisse, Deutsche Bank, Goldman Sachs and JPMorgan Chase & Co. have all published their forms, as have KCG Holdings Inc., Liquidnet Holdings Inc. and Investment Technology Group Inc.
IEX Group Inc., a trading platform started almost a year ago to neuter some of the tactics of high-frequency traders, handles almost 1 percent of U.S. equity volume. The upstart venue published its own Form ATS just before opening its market to investors in October. It has since become the sixth-largest private market in the U.S., according to data from Finra.
Seeking Transparency
The market is looking for someone that is transparent, said Spark Capitals Alex Finkelstein, who led the last round of funding for IEX. They want a company like IEX to happen.
Even as it grapples with competition from IEX, the industrys newfound transparency has its limits. Investors still dont have enough information to understand how their orders are processed, according to Dave Lauer, the president of consulting firm Kor Group LLC.
Everyones kind of racing to publish something, Lauer, who owns a stake in IEX, said in a phone interview. The question is more around what is being disclosed, the quality of whats being disclosed, and why its being disclosed.
Kor Group unveiled a service last week that enables institutional investors to see how brokers handle their orders. Tabb Group LLC, a research firm, announced a similar product on the same day.
Investors are increasingly requesting execution and routing information from their execution partners, but most buy- side firms lack the expertise to know exactly what to ask for, how to analyze the massive stream of information and — more importantly — how to interpret the results, Chief Executive Officer Larry Tabb said in a statement.
Many dark-pool operators amended their Form ATS shortly before publishing them, for example.
The cleansing of the Form ATS and then publishing it, that doesnt tell us much about the past, Lauer said.
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