Dark Pools Face SEC Restraints Curbing Fastest-Growing Markets

By Jesse Westbrook and Whitney Kisling

Oct. 21 (Bloomberg) -- The Securities and Exchange Commission may halt the expansion of the fastest-growing stock networks in the U.S. with rules to improve transparency in so- called dark pools.

The SEC will today propose lowering the amount of daily volume in a company’s shares that can be executed on the systems before quotes must be made public to 0.25 percent from 5 percent, according to two people familiar with the matter. Dark pools are electronic, off-exchange platforms that investors use to avoid revealing who they are and what they are trading.

Democratic Senators Charles Schumer of New York and Ted Kaufman of Delaware are urging regulators to crack down on practices they say create an unfair advantage for the biggest investors. Regulators proposed banning so-called flash trades, in which some investors get a half-second glimpse at share orders before the public, last month.

“It will initially take money out of many dark pools’ pockets,” said Matthew Samelson, the Stamford, Connecticut- based founder of market research firm Woodbine Associates Inc. “They’re either going to have to adjust their pricing to be more competitive with the current displayed markets or that flow’s going” elsewhere, he said.

The proposal is the latest sign the SEC is toughening oversight of strategies spurred by the growth of alternative exchanges and advances in technology. Dark pools are sometimes used by so-called high-frequency traders, brokerages that execute thousands of orders in a second to profit from tiny price gaps.

Sigma X

Trading on dark pools such as Zurich-based Credit Suisse Group AG’s Crossfinder and New York-based Goldman Sachs Group Inc.’s Sigma X, the two largest, has more than quadrupled to 9.4 percent of all U.S. equity volume in three years, according to Tabb Group LLC, a New York-based financial-services consultant.

Under the SEC plan, dark pools will have to publicly report quotes once they handle 0.25 percent of a stock’s daily average volume. The electronic networks usually shut down trading in a security when they approach the existing 5 percent limit.

John Nester, an SEC spokesman, declined to comment.

NYSE Euronext and Nasdaq OMX Group Inc., operators of the biggest U.S. stock exchanges, may benefit from the rule change, according to Woodbine’s Samelson. Both have suffered market share losses as investors shifted to newer venues.

The New York Stock Exchange handled 28 percent of all U.S. equity trading in September, while Nasdaq processed 22.7 percent. Their combined share has fallen to 50.7 percent from 74.1 percent in March 2006.

Block Exemption

The SEC will exempt block trades, or orders exceeding a certain number of shares, from the new rule, according to one of the people, who declined to be named because the discussions were private. Firms specializing in blocks account for 8 percent of all dark-pool trading in the U.S., according to data compiled by Aite Group LLC, a financial-services consultant in Boston.

Transactions are biggest at New York-based Liquidnet Holdings Inc. and Pipeline Trading Systems LLC, where orders average 50,000 shares. That compares with 300 to 450 shares at venues such as Getco Execution Services, run by Chicago-based Getco LLC.

Dark pools reduce costs and benefit small investors by letting mutual funds buy and sell securities in private, Goldman Sachs said in a statement posted on its Web site yesterday.

“Institutional investors can improve their trading performance by executing in an anonymous manner that diminishes their footprint,” according to Goldman Sachs, the most- profitable securities firm in history. “In doing so, the clients of these institutional investors, for example mutual funds and pension funds where the bulk of small investors have their money invested, are direct beneficiaries.”

Siphoning Liquidity

Growth of the networks is hurting traditional markets, which face more regulation, the World Federation of Exchanges said in a letter last month to Mario Draghi, chairman of the financial-stability board of the Basel-based Bank for International Settlements.

“The more the dark pools exist without any comprehensive regulation, the more you’re going to see liquidity siphon off from exchange markets,” William Brodsky, the chief executive officer of the Chicago Board Options Exchange and chairman of the WFE, said at a conference in Vancouver on Oct. 7.

The new SEC threshold may push smaller orders off of dark pools and onto exchanges, analysts said.

“If you were to limit the dark pools to that small amount of trading, it will be much harder to find a counterparty,” said Dirk Hoffmann-Becking, a London-based analyst for Sanford C. Bernstein & Co. For stock exchanges, “if they would see less competition from the dark pool world, that would certainly be a positive for them.”

To contact the reporters on this story: Jesse Westbrook in Washington at jwestbrook1@bloomberg.net; Whitney Kisling in New York at wkisling@bloomberg.net.