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Dark Pool Crackdown Will Harm Investors, Ex-SEC Officials Say

The Securities and Exchange Commission will harm mutual funds should it force private venues known as dark pools to immediately announce they have executed orders, according to two former officials at the agency.

The SEC proposed in October that the industry’s market data feeds include one more piece of information: the name of the dark pool that handled a given stock trade. This shift could cause money managers such as mutual funds and pension funds to get worse prices when they buy or sell large amounts of stock, Robert Colby and Erik Sirri said in the April issue of “Capital Markets Law Journal.” They ran the SEC’s division of trading and markets during the financial crisis of 2007 and 2008.

Money managers turn to private, off-exchange platforms in part to avoid tipping off high-frequency traders, whose strategies include trying to detect when large blocks that may sway prices are being bought and sold. While institutional investors seek to mask their intentions, the SEC says that letting investors know a given trade was filled through a specific dark pool will improve market transparency.

“If you try to force institutions to show their orders, they’ll just change their trading practices,” Colby, who was deputy director of the SEC’s division of trading and markets when he left the agency after 27 years in February 2009, said in an interview. “The commission has to be very cautious when they try to get institutions to do things they’re not willing to do.”

SEC Review of Markets

Colby and Sirri commented on the dark-pool proposal in a 28-page report outlining the SEC’s decades-long effort to balance the benefits of having most transactions take place on a single exchange with the advantages of multiple competing venues.

Colby is an attorney at Davis Polk & Wardwell LLP in Washington. Sirri is a finance professor at Harvard Business School and is on leave from Babson College in Babson Park, Massachusetts, where he has taught since 1995. He was director of the SEC’s division of trading and markets under Chairman Christopher Cox from August 2006 to April 2009.

Dozens of brokers, securities industry associations and asset managers such as Fidelity Investments have criticized the SEC’s proposal to require the identification of dark pool trades in real time. Right now, while dark pool trades show up publicly as they happen, they are anonymous.

Cutting Costs

“Dark pools can reduce transaction costs by limiting potential information leakage and associated market impact that can occur when trading significant blocks of stock,” Fidelity told the SEC in a February letter. “Real-time, post-trade transparency would substantially increase the risk that Fidelity’s trading activities would be prematurely signaled to the market, allowing opportunistic traders to front-run our investors.”

The SEC’s proposal requiring dark pools to identify themselves is part of a series of changes designed to give investors more information about where trading is taking place. In January, the SEC also published a discussion paper about market structure that asked for public comment on a range of issues relating to dark pools and high-frequency trading.

The agency questioned whether too much volume is occurring away from the public stock exchanges and whether its trading rules have kept pace with the growth of technology. The SEC broached ideas such as requiring orders to be displayed for one second before they can be cancelled and measures that could curtail the ability to transact away from exchanges.

More Volume

Dark pools handled 10 percent of U.S. equity trading in February, up from 5.8 percent in March 2008, according to data compiled by Rosenblatt Securities.

Colby and Sirri also argued that individual investors can benefit from having their orders routed off exchanges, so the SEC shouldn’t create barriers preventing that. Discount brokers doing business away from exchanges may receive better prices for their customers, and the process known as payment for order flow can help the firms keep trading costs low, they said.

They criticized a part of the SEC’s concept release that asked whether market makers should be required to improve prices when trading orders off exchanges instead of simply filling them at the best bid or offer. Currently brokers can trade at the best price away from exchanges. The SEC’s idea, called a trade-at rule, would allow market makers and brokers to transact at the best price only if they were already quoting at that level when they received the order.

Eight brokers with “significant retail customer accounts” send almost all of their orders that can be executed immediately to market makers executing off exchanges, the SEC said in January. Those firms pay many of the brokers sending orders less than one-tenth of a cent per share for the orders. Orders traded on exchanges usually pay fees of up to three-tenths of a penny.

“With retail customers, the SEC needs to be very careful to make their life better, not worse,” Colby said in the interview.

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