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.

“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.”