As Market Heats Up, Trading Slips Into Shadows

March 31, 2013

By NATHANIEL POPPER

Wall Street is embracing its dark side.

As the stock market continues to climb, trading has increasingly migrated from established bourses like the New York Stock Exchange to private platforms, including dark pools, that are largely hidden from public view. The shift is helping big traders hide what they are doing in the markets, and regulators are worried that the development could obscure the true prices of stocks and scare away ordinary investors.

The movement, under way for several years, has gathered force recently. The portion of all stock trading taking place away from the public exchanges hit new highs over the last few weeks, amounting to close to 40 percent on several days, up from an average of 16 percent in 2008, according to Rosenblatt Securities.

The trend has bucked the government’s broad effort in recent years to move more of the financial industry out of the back rooms and into the light. The increasing opacity of stock trading in the United States, long the most transparent place in the financial world, is troubling for investors and regulators.

“We’ve been having a lot of discussions about whether we are reaching a tipping point between lit and unlit markets,” said Thomas Gira, head of market regulation at the Financial Industry Regulatory Authority, the industry-financed regulator.

In March, Australia introduced new rules to limit trading off-exchange, following the lead of Canada, which put regulations in place last fall. In the United States, the Securities and Exchange Commission has so far declined to act.
The concerns are also evident in the industry itself, where a few dark pools have recently been advertising tools that promise to keep out “gaming” and “toxic” trading practices going on in other dark pools.

Dark pools, like public exchanges, give investors a place to connect with buyers and sellers of stock, but the pools are subject to less stringent regulations than public exchanges. Often run by big banks, dark pools do not require buyers and sellers to publicly announce their intention to trade stocks, allowing traders and investors to hide behind a veil that only the operator of the pool can penetrate.
That appeals to a pension fund that wants to buy a million shares of Ford stock, for instance, because it allows the fund to avoid tipping off competitors who could push the price of the stock up.

Investors also have said that they have moved more of their trading into the dark because they have grown more distrustful of the big exchanges like the N.Y.S.E. and the Nasdaq. Those exchanges have been hit by technological mishaps and become dominated by so-called high-frequency traders.

But the biggest factor pushing trading away from the public exchanges is the ongoing decline in volatility in stock prices, traders say. When share prices are rising or falling sharply, investors want to quickly and reliably get their trade done, leading to a preference for the safety of an exchange. In calmer trading, on the other hand, the anonymity of dark pools is more attractive. What’s more, dark pools are generally cheaper to use than an exchange.

Other places besides the 30-plus dark pools are stealing the business of stock exchanges. A handful of firms including Citigroup and Knight Capital pay retail brokers like TD Ameritrade and Scottrade for the opportunity to trade with ordinary retail investors before the orders can reach an exchange, a phenomenon known as internalization. This type of off-exchange trading has also been growing, in part because of the recent revival of interest in the stock market among ordinary investors.

In recent weeks, internalization has accounted for about 60 percent of off-exchange trading and dark pools for about 40 percent.

The complicated structure of the stock markets makes it hard to get reliable numbers on the exact amount of trading going on in the different entities. Some operators of dark pools say that the most widely used numbers misrepresent the amount of trading going on in the dark, and ignore the fact that on public exchanges some types of trading happen out of the public eye.

Dan Mathisson, the operator of the nation’s largest dark pool, Credit Suisse’s CrossFinder, said that American regulators should not introduce new rules just because of the fears surrounding dark pools.

Mr. Mathisson also said that dark pools have not had the technology problems that have done real harm to investors.

Trading in the dark is just one of the facets of the turbocharged stock market that lawmakers have been examining. High-frequency trading has often grabbed the public spotlight. But while high-speed traders have been dialing back their activity, trading in the dark has kept rising.

Canada has been among the most aggressive countries in confronting dark trading, introducing rules last fall that allow trades to take place in dark pools only if brokers are getting customers a significantly better price than is available on the public exchange. Within months, dark pool trading in Canada dropped to about a third of what it was before the rule, according to Rosenblatt Securities.

Regulators and long-term investors fear that the movement away from exchanges will diminish part of what has made the American stock market the envy of the world: the public auction process. In off-exchange trading, investors cannot see what trades are available and as a result are not encouraged to offer a better price.

A recent study by researchers in Australia found that the cost of trading went up for all traders when more trading happened in the dark, backing up an earlier study by an economist at Rutgers, Daniel Weaver.

“If long-term investors are being siphoned off and sent away from the exchanges, there will be less competition and prices will get worse,” said Mr. Weaver.

Because most dark pools and internalizers are operated by banks, Finra, the industry-financed regulator, is also worried that the banks can provide a sneak peek of the trading their customers are doing to their own traders and selected customers. Last September, Finra began gathering information from 15 of the largest dark pools and is now trying to determine whether the banks have improperly shared information about the customers in their dark pools.

“We’ve seen some problematic activity when we’ve looked at” dark pools in trading exams, said Mr. Gira, Finra’s head of market regulation.

Among long-term investors, 67 percent said that they have “trust issues” with dark pools, according to a survey last year by the Tabb Group.

Kevin Cronin, the top trader at the mutual fund provider Invesco, said that to buy and sell stocks in his firm’s mutual funds he has to dedicate an increasing amount of time and money navigating the dark pools. There is too much trading going on there to avoid it, he said.

Last month, Invesco hired a top trader from Mr. Mathisson’s company, Credit Suisse, to keep up with the latest technological developments.

But Mr. Cronin said that he worries as he and other traders escalate the amount of business they are doing out of the public eye.

“It’s just not an efficient market if a fair amount of orders never see the light of day,” he said. “We should all be concerned about this.”