A closer look at dark pool regulation

Frum FierceFinance;

Last November, the SEC proposed a set of regulatory changes regarding trading in "dark pools," with an emphasis on the use of IOIs (indications of interest) as a means of passing information to privileged traders. The SEC sees the practice as an impediment to market transparency. Others have claimed it perpetuates a "two-tier system," whereby only certain traders have access to complete share information. While it is impossible to predict the wider effects of new regulation with certainty, there are several possible outcomes.

A return to "upstairs markets"

Back before the advent of dark pools, institutional traders carried out large trades through dealings in "upstairs markets," trading floors which run parallel to major exchanges. These offered large investors the same advantages offered by dark pools: The opportunity to locate counterparties and negotiate trade terms, while significantly reducing the market impact that could follow trading through a public exchange.

These upstairs markets still exist, however, and still provide a valuable service for large investors. Large investment banks offer general traders access to their research analysts and elaborate predictions about market activity. Investors pay a hefty commission for this information, and the upstairs markets have remained useful for this reason. But dark pools still offer a venue through which trades may be executed more cheaply and more quickly.

IOIs, in this case, have provided a service similar to what the upstairs markets provided, by allowing investors to locate counterparties and make large over-the-counter trades without exposing their actions to the public. The SEC proposals have targeted IOIs in an attempt to force traders to translate their IOIs into the quote system, thereby making the information available to the public. The problem is that this might only force traders to find new routes for transfer of this information, one of which may be a return to upstairs markets for trading. According to Traders, attempts to regulate privileged access to such flows of information are futile because such information is, in fact, far too valuable: "Until a rule change comes along that confronts this reality, regulations intended to eliminate the upstairs market will be exercises in regulatory vanity.



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http://www.fiercefinance.com/story/closer-look-dark-pool-regulation-continued/2010-02-16