Recent developments that call into question dark pool
trading activities may not deter institutional investors from
seeking out alternative trading venues and taking full
advantage of their benefits. The most recent development saw
the Securities and Exchange Commission fine dark pool operator
eBX which runs Level ATS $800,000 in October
for allegedly failing to protect customers confidential
trading information. But if more such cases arise, investors
will likely start looking more closely at whether the venues
deliver what they promise.
Thats the finding of Woodbine Associates, a capital
market research and consulting firm based in Stamford,
Connecticut. It advises clients on dark pool selection and
released a report in September on current dark pool trading
Despite SEC charges brought against eBX, institutional
investors need dark pools more than ever today, says
Matthew Samelson, principal at Woodbine Associates. Samelson
points out that because todays traditional display
markets such as the New York Stock Exchange or Nasdaq trade at
lightning-fast speeds, the buy-side institution that is not a
low latency or high frequency trader is at a distinct
It behooves these institutional traders to trade in
dark pools where they have some control over who they interact
with, can have anonymity and more protection against leakage
than one gets in the display markets and thus, can achieve some
kind of trading price improvement, he said. Currently,
there are more than 40 dark pool trading venues operating in
the United States.
As an example of dark pool benefits, Samelson said that a
firm that wishes not to interact with high frequency trading
flow or with another type of counterparty can depending
on the dark pool they use utilize controls to
achieve that goal.
According to Dark Pools: Characteristics, Operations
& Liquidity, an analysis of 25 different dark pool
trading venues issued by Woodbine Associates in September,
off-exchange transactions account for 27 percent to 34 percent
of all U.S. equity securities volume, with dark pools
representing a smaller but persistent proportion of that
volume, growing from 8 percent of the consolidated tape share
volume in 2008 to approximately 13 percent today.
But if institutional investors continue to trade in these
opaque trading venues, is there a way for them to avoid
Samelson says that for now, their options are limited.
If someone misrepresents something to you, either by
omission or intentionally, there is no way you can find out
whats really going on, short of doing your own internal
audit of the situation, he said.
However, he acknowledges that recent events may make some
people both institutional and Main Street investors
quite nervous about market operations.
The eBX episode is one of several that have raised questions
of late concerning dark pool operations. The firm was
sanctioned by the SEC and paid a penalty but did not admit or
deny wrongdoing. Earlier in June alternative trading network
Liquidnet Holdings said that the SEC was investigating how it manages
information about the firms using its platform. And the
previous October, Pipeline Trading Systems paid a $1 million
penalty to the SEC to settle charges that the broker failed to
disclose to customers that a majority of orders were not
processed as advertised, that is, matched against other
Pipeline customer orders. Instead, a majority of orders were
filled by a wholly owned trading affiliate of the firm. As with
Liquidnet, Pipeline did not admit or deny the charges. As a
result of such developments, Samelson says Woodbine sees a
business opportunity and is looking into the possibility of
conducting trading audits and validating the operations of dark
pool venues for the benefit of institutional clients.
A validation would involve numerous audit-type
features to basically ensure that what a dark pool specifies is
the case in terms of their operations and practices
[are], in fact, as they say, he says.
The validation service would be provided to and paid for by
dark pool operators who hope to attract and retain their
institutional trading customers. It could involve a
comprehensive review of business processes or alternatively, a
more selective review and audit of the code underlying their
matching engine to validate that the way management or a sales
team says an offering works is truly the way it operates.
The scope of such work is likely to be dependent upon
what the dark pool thinks is necessary, Samelson
He adds that Woodbine is in talks with certain dark pools to
validate their operations.
Industry observers say such a service would be a first.
Currently, industry surveys such as the TABB Groups
Liquidity Matrix and the monthly Let There Be Light
activity reports, issued by institutional broker-dealer
Rosenblatt Securities, report on dark pool trading volumes and
pricing activity. But there do not appear to be any other
organizations that offer something akin to an audit or
validation of dark pool operations. The TABB Group, for
example, reports that to their knowledge, no such service
You would think that the regulators would be doing
that (providing audits of dark pool activity) already,
says Joe Saluzzi, co-founder at Themis Trading, an independent,
institutional agency broker based in Chatham, New Jersey, and a
frequent critic of the trend toward what he calls an
uneven playing field in markets. He adds that while he
would welcome the existence of such a service, if a pool
did not want to be validated, you would certainly have to ask
Others questioned whether dark pools would be willing to
disclose much about their operations.
David Mechner, CEO at Pragma Trading, a New Yorkbased
provider of advanced trading tools, observed that before anyone
even attempts to audit a dark pool, one would have to get dark
pool operators in particular, broker-sponsored dark
pools to articulate more clearly what their rules of
operations are, something that would be very difficult to do.
For all the noise about exchange order types, 30-plus
percent of volume is done off exchange, much of it in
broker-sponsored dark pools with very little disclosure about
the rules for how those orders are handled.