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[IWS] CRS: DARK POOLS IN EQUITY TRADING: POLICY CONCERNS AND RECENT DEVELOPMENTS [26 September 2014]

IWS Documented News Service
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Institute for Workplace Studies----------------- Professor Samuel B. Bacharach
School of Industrial & Labor Relations-------- Director, Institute for Workplace Studies
Cornell University
16 East 34th Street, 4th floor---------------------- Stuart Basefsky
New York, NY 10016 -------------------------------Director, IWS News Bureau
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Congressional Research Service (CRS)

Dark Pools in Equity Trading: Policy Concerns and Recent Developments
Gary Shorter, Specialist in Financial Economics
Rena S. Miller, Specialist in Financial Economics
September 26, 2014
[full-text, 18 pages]

Summary
The term “dark pools” generally refers to electronic stock trading platforms in which pre-trade
bids and offers are not published and price information about the trade is only made public after
the trade has been executed. This differs from trading in so-called “lit” venues, such as traditional
stock exchanges, which provide pre-trade bids and offers publicly into the consolidated quote
stream widely used to price stocks.

Dark pools arose partly due to demand from institutional investors seeking to buy or sell big
blocks of shares without sparking large price movements. The volume of trading on dark pools
has climbed significantly in recent years, from about 4% of overall trading volume in 2008 to
about 15% in 2013. While dark pools reportedly have lower trading fees, their lack of price
transparency has sparked concerns about the continued accuracy of consolidated stock price
information. In addition, fairness concerns have surfaced in recent regulatory and enforcement
actions, in the press, and in Michael Lewis’s book Flash Boys over allegations that dark pool
operators may have facilitated front-running of large institutional investors by high-frequency
traders, in exchange for payment, and misrepresented the nature of high-frequency trading in the
dark pools.

This report examines the confluence of factors that led to the rise of dark pools; the potential
benefits and costs of such trading; some regulatory and congressional concerns over dark pools;
recent regulatory developments by the Securities and Exchange Commission (SEC) and the
Financial Industry Regulatory Authority (FINRA), which oversees broker-dealers; and some
recent lawsuits and enforcement actions garnering significant media attention. These include a
2014 civil suit filed by New York Attorney General Eric Schneiderman against the securities firm
Barclays for its dark pool operations. A central allegation was that in marketing materials for
prospective investors, Barclays misrepresented the extent and nature of the high-frequency
trading in its pool. The report also examines steps regulators in Canada and Australia have taken
to address any reduction in price transparency from dark pool trading.

Traditionally, the exclusive locales for stock trades were exchanges such as the New York Stock
Exchange and NASDAQ. In recent decades, the availability of cheaper and more powerful
computers and at least two SEC regulations—Regulation ATS and Regulation NMS—helped give
rise to an array of alternative trading venues that include dark pools. SEC Chair Mary Jo White
and others have voiced concerns that the pools impede the overall process of price discovery in
stocks. Proponents of dark pools, however, point out that they have lowered trading costs and that
they may afford faster trading or superior technology and enable investors to buy or sell larger
blocks of stocks without moving the market.

In an effort to increase market transparency, FINRA in 2014 began requiring dark pools to report
their aggregate weekly volume of transactions and the number of trades executed in each security.
In June 2014, White asked SEC staff to draft recommendations for expanding the scope of
operational disclosures that dark pools would have to provide to the SEC and the public. The SEC
also announced a pilot project dubbed the “trade-at” rule, in which off-exchange trading venues,
including dark pools, could execute orders only if they provided a significant price improvement
or size improvement over “lit” venues. Both Canada and Australia saw significant reductions in
dark pool trades after adopting such trade-at rules. Critics of the trade at rule include brokerage
firms, some of whom own dark pools. Congress has examined regulatory concerns over dark
pools in a number of 2014 hearings on high-frequency trading as part of its oversight over the
SEC.

Contents
Introduction ...................................................................................................................................... 1
What Is a “Dark Pool”? ................................................................................................................... 1
Factors That Contributed to the Growth of Dark Pools ................................................................... 4
Non-Regulatory Factors ............................................................................................................ 4
Regulatory Factors ..................................................................................................................... 5
Potential Regulatory Concerns ........................................................................................................ 6
Market Fragmentation ............................................................................................................... 6
Fairness and Access ................................................................................................................... 7
Price Manipulation .................................................................................................................... 7
Potentially Improper Trades ...................................................................................................... 7
Price Discovery ......................................................................................................................... 8
Regulatory Developments................................................................................................................ 9
FINRA’s New Trade Data Disclosure Requirements................................................................. 9
The “Trade-at” Rule ................................................................................................................ 10
Canada and Australia Adopt “Trade-at” Rules .................................................................. 11
The Potential for Future Regulation .................................................................................. 11
Enforcement Developments ........................................................................................................... 11
New York Attorney General Sues Barclays ............................................................................. 12
SEC and FINRA Probes and Some Enforcement Actions ....................................................... 13

Contacts
Author Contact Information........................................................................................................... 14
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