"Dark pools" marketplace may face pruning

25. Feb. 2010

NEW YORK - The surprising growth of U.S. stock trading venues is set for a pruning as regulators prepare to tighten controls on so-called dark pools and as brokers, still pinching pennies, look to narrow where they send orders.

Dark pools are a type of alternative trading system, or ATS, that allow investors to anonymously trade larger blocks of stock without tipping their hand to the wider market.

At more than 40, they've exploded in the last five years to meet investors' growing demand, fragmenting and complicating the marketplace like never before.

While the U.S. Securities and Exchange Commission is worried this fragmentation could harm public prices and long-term investors, others are concerned about the mounting costs associated with routing orders to the most appropriate of many destinations.

This all suggests that some ATSs -- particularly the smaller, independent ones -- could disappear in a consolidation, marking a significant shift from the regulation-inspired explosion that has siphoned trading volume from New York Stock Exchange, Nasdaq Stock Market and other traditional exchanges.

"It makes sense and it's made some sense for a while," said Jamie Selway, managing director of institutional broker White Cap Trading, and a BATS Exchange board member.

"Potentially the operating costs go up for (ATSs) with the regulatory tightening. There is decreasing marginal return for people running these things, and an even harder market in terms of ... less money for technology projects," he said. "Budgets are tight, particularly technology and regulatory budgets."

The last industry-wide consolidation came between 2000 and 2006 with the various mergers of alternative venues BRUT, Instinet, Island, and Archipelago, which all ended up acquired by what are now NYSE Euronext (NYX.N) or Nasdaq OMX (NDAQ.O).

But new rules in 2005 known as Regulation National Market System (Reg NMS) forced exchanges to electronically route orders to the venue with the best price, sparking another growth spurt that the SEC hoped would curb exchange monopolies, and inspire innovation and diversity in the marketplace.

It certainly had the desired effect. Perhaps too much so.

"After having favored ATSs by exempting them from exchange requirements, the commission is now considering whether the success of the ATSs has had another effect of creating (unwanted) fragmentation," and whether they should be brought more in line with the requirements of exchanges, Robert Colby, former deputy director of the SEC's trading and markets division, told the Capital Markets Consortium this week.

Reg NMS has brought "significant fragmentation of orders and high search costs for large orders," said Colby, who is now counsel at law firm Davis Polk & Wardwell LLP.

DARK POOLS UNDER THE GUN

The public comment period ended Monday on the SEC's three dark pool proposals: to ban private electronic messages known as indications of interest, or IOIs; lower the threshold at which the ATSs must display quotes for a single stock; and require them to report trading in real time.

The SEC also devoted much space to dark pools in a 74-page paper on market structure and high-frequency trading that it issued last month, which also requests public comment. "Whether fragmentation is in fact a problem in the current market structure is a critically important issue ..." the SEC said.

"Undisplayed" trading accounts for about a quarter of all volume, according to the regulator. Most of that is executed in-house at banks such as Credit Suisse Group AG (CSGN.VX), Goldman Sachs Group Inc (GS.N) and other broker-dealers that "internalize" orders in their own dark pools.

Any consolidation, rather, is likely to occur among the independent or consortium-owned ATSs that have a less stable flow of orders, and that are more vulnerable to rule changes.

"If it's a fragmented dark pool with no electronic liquidity provider, then, standing alone, it may be hard for them to gain a lot of market share," said George Hessler, an industry veteran and former executive vice president at Lime Brokerage.

There are mixed signals as to whether an ATS consolidation has begun.

NYFIX, a trading technology firm bought last year by NYSE Euronext, agreed separately in November to sell its Millennium dark pool to BNY ConvergEx Group. Headed in the other direction, trading systems provider Pragma Securities launched the ONECROSS dark pool earlier this month.

Big advances in brokerages' order-routing technology is probably why consolidation has not occurred over the last few years, Whit Conary, president of dark pool LeveL ATS, said of the industry in general. "It is unlikely that regulatory changes will bring about consolidation in ATSs."

But Conary, whose Level launched in 2006 and is backed by five financial companies including Citigroup Inc (C.N) and mutual fund giant Fidelity, added that mergers could work from a business perspective if the ATS models are substantially different and can expand on the offering to the customer.
[Reuters]