Regulators, Don't Drain Dark Pools

Regulators, lawmakers and investors are all trying to penetrate murky dark pools. Increased scrutiny of these private stock-trading platforms is well deserved. But it's also important to remember that well-regulated dark pools serve a crucial purpose in the markets.

Dark pools permit large blocks of shares to be traded anonymously, delaying notification to the market until trades are completed. This opacity has made some client orders vulnerable to predatory trading practices by high-frequency traders. As scrutiny of dark pools' usefulness and risk intensifies, market participants have been left wondering whether they have outpaced the regulatory structure and now threaten market confidence and integrity.

Such concerns have been compounded by a recent decision from Hong Kong's Securities and Futures Commission to bar dark pools from accepting retail investors' trades beginning on Dec.1, 2015. This means that pools are open exclusively to institutional investors. In addition, the SFC's proposed mandate will force dark pools to comply with some of the same requirements that exchanges face, such as disclosing the types of orders available through their platforms and the sources for their pricing data.

Amidst all the negative headlines, dark pools' raison d'être has become obscured. The simple fact is that dark pools help reduce large trades' enormous transaction costs and are extremely helpful in providing the market with liquidity. Regulators need to ensure these platforms fulfill their intended purpose instead of simply shutting them down.

Market-Strengthening Innovations
Dark pools were originally designed to enable investors to anonymously trade large blocks of shares with the specific intention of executing an entire trade at a fixed price. By enabling investors to make large transactions, dark pools can reduce trade costs, provide greater market liquidity and facilitate faster trades.

Investors developed confidence in dark pools as a safe way to conduct these large transactions at a fixed price, and many big banks now offer dark pools to their customers. Although there is ongoing confusion regarding regulators' powers to oversee off-exchange markets, regulators such as the Securities and Exchange Commission, Commodity Futures Trading Commission and Financial Industry Regulatory Authority can indeed monitor dark pool activities and initiate enforcement actions when warranted. It seems clear that well-regulated dark pools should have a place in the financial ecosystem as useful, liquidity-driven innovations that help strengthen the ability to trade internationally.

Pool Closed for Cleaning

But dark pools have attracted a lot of negative publicity in the wake of strict regulatory enforcement actions. Facing allegations that their dark pools favored high frequency traders over their own clients, some banks have chosen to close their dark pools, lest they be subjected to large penalties.

If regulators' intent was to restore investor confidence, these actions had the opposite effect. The large fines imposed on the banks threatened their business line and led them to scale back operations and lay off employees, which slowed activity. Banks refunded customers their money and sold the assets of the now-defunct dark pools, further lowering confidence in alternative trading systems and dragging down overall trading volume. Low volumes have since become the norm.

Protect Investors, Not Exchanges
Just as U.S. regulators went after dark pools in 2014, the European Securities and Markets Authority appears poised to put in place their own policies to limit activity in these opaque exchanges. Not only would this threaten market activity and liquidity, some suggest that volume caps on dark pools are unlikely to work.

As recently as April 2015, European lawmakers voiced the opinion that volume caps on dark pool trading activity would not so much impose restrictions as kill dark pools altogether. This was based on a study by the London Stock Exchange which found that all but one of the Financial Times and the London Stock Exchange stocks would breach the proposed volume caps. It's a strange state of affairs when lawmakers are simultaneously incorporating volume caps into their directives and second-guessing the effectiveness of the approach.

Whatever the ultimate solution, regulators will not protect investors' interests by closing down dark pools. Rather, it is their duty to protect investors by ensuring that these venues are not coopted by nefarious actors. In this way, ordinary investors can flourish.

Christian Asare is a senior project manager at Clutch Group. He previously worked as a senior regulatory consultant for the FCA and as a derivatives trader. Keisha Potter is an associate at Clutch Group.