6 October 2020 Issue Brief

Dark Pool Trading System & Regulation

The effective regulation of “dark pools”, which are private forums for trading securities, is necessary to secure efficient trade execution, and to ensure transparent and fair markets as a means of fostering confidence and trust in trading markets.

Within the current, fragmented securities-trading market environment, off-exchange trading, including broker/dealer internalization and dark pools in which prices are not displayed prior to execution, has grown significantly. Non-exchange trading in the U.S. has surged in recent years, accounting for an estimated 40% of all U.S. stock trades in spring 2017, compared with an estimated 16% in 2010. Dark pools have been at the forefront of this trend towards off-exchange trading, accounting for 15% of U.S. volume as of 2014.

From a market integrity perspective, the growth in dark trading raises potential concerns, ranging from a perceived decline in the transparency of markets to a reduced willingness of investors to display quotes if dark venues free ride on those quotes and privatize order flow. CFA Institute members have raised concerns that the incentive to display orders in public markets is being undermined by certain off-exchange trading practices. In turn, these concerns have implications for public price discovery, liquidity, and the quality and integrity of markets.

Dark Pool Regulation

The SEC issued an Equity Market Concept Release in 2010 (PDF) that discussed, among other things, dark pools as part of alternative trading systems (ATS), and in terms of trade rule reporting, market liquidity, and order execution quality.

In 2009, the SEC proposed to amend the Exchange Act of 1934 regulations (PDF) that apply to nonpublic trading in Regulation National Market System (Reg NMS) stocks, including dark pools.

In late 2015, the SEC proposed amendments to requirements under Regulation ATS (PDF) pertaining to ATS that trade in Reg NMS stocks, including dark pools.

CFA Institute Viewpoint

CFA Institute believes that regulation should not favor one type of firm or person over any other when they engage in economically and functionally similar activities. Consequently, any regulatory or legislative advantages, such as those that permit broker-internalization networks to operate under different rules from exchanges despite their similar activities, should be eliminated.

Our dark pools report identified how increasing the opacity of trading, principally through internalization, will undermine improvements in trading costs with impaired price determination and wider spreads. To avoid these negative repercussions, regulators should monitor growth of dark trading volume and improve reporting and disclosure around dark pool trading to enable appropriate measures by investors and regulators, alike.

CFA Institute also supports rules that would allow regulators to limit dark pools trading to “large-in-scale” orders if these systems become too dominant.

For firms to internalize retail orders, they should have to provide meaningful price improvement or route the orders to regulated exchanges to interact with displayed quotations in the order book.

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