The question is constantly out there—Will the SEC place new regulations on non displayed pools of liquidity otherwise known as “dark books?” That was the topic of discussion at a Liquidnet press breakfast (April 18)featuring Seth Merrin, Liquidnet’s founder, and Harvey Pitt, former SEC Chairman and now consultant of Kalorama Partners based in Washington, D.C.

There weren’t any answers—but that wasn’t the point—there was a lively discussion about the future market structure and some suggestions as to how the SEC might go about reviewing the burgeoning numbers of dark books.

Harvey Pitt, who was at the SEC's helm from 2001-2003, understands its inner workings and believes the Commission is taking the right approach. “They are talking about issue and looking at issue---they are not acting on this issue yet.”

The issue he is referring to is the growing number of dark pools and the market fragmentation they are causing. The number of non-displayed liquidity pools one year ago was about four, today reports say there are as many as forty. Why could this be a problem? “Fragmentation can produce disproportionately bad pricing,” Pitt explains.

Many of the newest dark pools are being created by broker-dealers to connect and automate the execution of internal order flow coming from once siloed areas—retail, proprietary, institutional, etc. These broker run alternative trading systems (ATSs) are dark in that they cross orders anonymously and do not quote out to the market. This may also be a concern to the SEC because it means an intermediary (broker) is representing both sides of the order, Pitt explains. However, both Pitt and Merrin point out that internalization of orders has always been done by phone, now it is being done electronically.

Despite these two areas of concern, Pitt suggests the SEC take a wait and see approach.
“They need to understand what’s going on and figure out if there is a problem with lack of transparency and, if there is, when does it arrive?”

Pitt believes that the SEC may be entering a period of change with Erik Sirri in the position of Director of Market Regulation. “Erik is not a lawyer, he’s an economist, and he thinks differently from the way a lawyer would think.” He may come at this with a new and different approach from past Commissions.

Pitt’s most important piece of advice to the SEC, is to use economist judgment and define how they want the market to function. Then set principles and standards to further that model.”

He suggests that past regulation has not always benefited the market. Enter: Regulation National Market System. The best execution requirements under Reg NMS equate best execution with best price, he says. Pitt argues that best price does not always mean best execution. “It may be for the guy trading a 100 share order, but if there is a 100,000 share order, that person’s best execution may be to get the entire trade done as quickly as possible or to execute it anonymously at the midpoint.”

“The buyers and sellers need to determine what is best for them, not the regulators and certainly not a 573 page rule,” Pitt exclaims.

But is the growth of dark pools a bad thing? Yes, they have a controversial name, and fragmentation could be an issue. But Merrin points out that often trading in these pools of liquidity get you better execution than if you traded on the open market, especially when trading large block orders. He also believes there will be consolidation among these pools of liquidity, which will assist with the market fragmentation issue. Many of these liquidity pools are forging relatinships to connect eachother's liquidity pools, similar to what happened in the late 90s with the ECNs.

The market share in these dark pools keeps climbing, so the SEC will probably continue to watch closely. Aite Group estimates the market share in dark pools has of NYSE listed stocks at 17%. Merrin says, unscientifically, he could see that number climbing to 25% by the end of this year. Overall (both NYSE and Nasdaq) marketshare in dark pools, Aite Group estimates to be 10%.

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