Dark Pools Opening Up Amid Increased Scrutiny

Dark pools, the private trading venues that together host more U.S. equity volume than the New York Stock Exchange, are opening up.

New rules on Wall Street this month are forcing dark pool operators to report trading details to regulators. KCG Holdings Inc., Liquidnet Holdings Inc. and IEX Group Inc. plan to share the information with the public. KCG and Liquidnet will also join IEX and Investment Technology Group Inc. in posting dark pool rule filings, known as Form ATS, on their websites.

The actions come as the platforms, which allow customers to hide orders to buy and sell stocks, face unprecedented scrutiny. New York’s attorney general has requested information as he probes equity markets, while Michael Lewis’s book “Flash Boys” suggested some dark pools cater to high-speed traders. The Securities and Exchange Commission has said it’s reviewing how the $23 trillion U.S. stock market operates.

“This is an evolution of the type of transparency we’ve previously seen,” Sayena Mostowfi, a New York-based analyst at Tabb Group LLC, said yesterday by phone. “The Form ATS being put on websites is a more formalized way of sharing the information.”

The public disclosures mark a shift for the markets, which accounted for 14 percent of total U.S. volume in March, according to Rosenblatt Securities Inc. On May 12, alternative trading systems, the category of stock venues that includes dark pools, began reporting volume and trade counts in individual securities to the Financial Industry Regulatory Authority. Finra will start issuing reports later this month, Chief Executive Officer Richard Ketchum said in a May 19 speech.

Sharing Data

Unlike public exchanges such as the NYSE, dark pools haven’t normally revealed details such as volume or pricing. While some venues share information with clients, the secrecy has led some critics to ask whether the platforms favor one type of customer over another. Publishing the Form ATS and revealing trade data is a “great first step,” toward transparency, Mostowfi said.

KCG told clients in a note this week that it will share with them the data it sends to Finra, which includes the number of trades, and shares traded, for individual securities. The firm, which already publishes information on how trading works on its Knight Match venue, will also make the dark pool’s regulatory filing public, it said in the letter.

“We will continue to support industry initiatives that enhance an investor’s ability to effectively manage orders and make routing decisions, such as this new off-exchange reporting requirement,” KCG said.

Setting Straight

Liquidnet also plans to make its Finra data public, and will soon publish its Form ATS on its website, said Adam Sussman, head of market structure. He joined Liquidnet this year from Tabb Group.

“There’s the potential for a lot of misperceptions of what dark pools are and how they operate,” Sussman said in a phone interview yesterday. “Part of this is trying to set the record straight.”

The firm has provided a copy of its trading rules to clients since it opened for business in 2001.

IEX said in a trading alert on its website that it will make the data it sends to Finra available on its site immediately after the information is sent to the regulator.

ITG said on May 1 that it would publish its Form ATS on its website, along with a plain-English guide to how the Posit dark pool operates. IEX made its filing public in October, just before the venue opened for business.

Unanswered Questions

Justin Schack, partner and managing director for market structure analysis at Rosenblatt, said he thought the increased transparency was in part prompted by increased pressure from clients for more information on what was happening with their orders, including to which other venues dark pools send unfilled requests. Releasing a Form ATS can be helpful, he said, though some filings are more detailed than others.

“It’s useful, but it’s not as if they answer every question an investor may have,” Schack said. “It’s a voluntary, principles-based reporting regime, so you can get a range of responses to the same thing.”

For example, some investors are concerned about whether a venue sets prices using direct feeds from exchanges or the slower public ticker, because the latter can create opportunities for high-speed traders to pick off other participants. Yet, some Form ATSs don’t say which type of feed the platform uses, Schack said.

The push for more transparency may go beyond dark pools. In a research report, Mostowfi noted that Finra’s new reporting rule doesn’t apply to retail wholesalers, which she estimated make up 19 percent of total U.S. trading volume. Wholesalers are market makers who pay for orders from brokerages and mostly fill them internally, not on public markets.

In his speech yesterday, Ketchum suggested that increased disclosure may eventually be forced on such venues.

“We intend to carefully consider whether to expand that rule to provide additional transparency for the large amount of non-dark pool trading that occurs away from exchanges,” he said.

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