Does NMS Support the “Dark Side”

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New York – There were two articles in the Wall Street journal yesterday worth discussing, The first was a brief discussion of the future of Reg NMS and the second was a much more prominent article on the growth of dark pools. We view that there is a relationship between these two market phenomena.

Reg NMS

At the center of Reg NMS is the rule of best price and the trade through rule. Both of these rules tend to support greater electronic trade flows and, as a result, less open outcry trade. As a result, one of the main beneficiaries of the regulation are the ECNs.

The Wall Street Journal article reported that the NYSE has asked for a delayed imposition of Reg NMS, because it has not been able to complete and test the necessary systems that the regulation requires to be in place. There is a large requirement for interconnectivity associated with this regulation. The NYSE has asked for implementation to be delayed to March 5th (from February 5th currently). It seems likely that the SEC will allow this change.

Dark Pools

The term dark liquidity refers to transactions conducted through non-transparent systems. The non-transparency refers to the anonymity of the participants of these trades. The name is really unfortunate, since it is just asking for regulatory scrutiny. How will it be until all of transactions move to the “dark side”?

There are currently about 40 dark pools if one adds the existing pools to those that have already been announced. These pools are runs by companies such as Liquidnet, Nyfix Millenium ATS and Pipeline Trading Systems, as well as companies that are now part of exchanges, such as Archipelago (NYSE) and Instinet (NASDAQ). Dark flows account for about 5% of overall market trade, so they are not yet a major part of the market. As well, they are not new. they were know by a more benign name of “internalization”, prior to being taken over by the Dark Lord.

Not Surprisingly, regulators have been trying to get their hands around these dark pools to see if any regulation is needed to control the way they are used by hedge funds and other sophisticated market participants.

We view the development of the dark pools as problematic only in the sense that there can be less transparency. For example, since the pricing is revealed to the market only after the transaction has occurred, bid/offer spreads could become less accurate if the pools become a major force in the market. Of greater concern is whether there are actually two markets and market clearing prices developing inside and outside the dark pools.

Combined Effect

In part, the growth of dark liquidity is related to the implementation of Reg NMS. First, the purchase of Instinet and Archipelago is a reaction to the impending imposition of Reg NMS. The rule of best price will give exchanges the burden of proof the investors did indeed get the best price available. As more transparent trade flow hits the electronic systems, the big players will naturally continue to seek ways to remain anonymous. One way is to work a deal through the market slowly, so as not to tip your hand. The other is to transact in dark pools.

Dark pool transactions are typically more expensive from the fee side but less expensive through attaining a lower price in a purchase (or a higher price in a sale). Given that the inter-dealer brokers need to find ways to improve their trading fees and commission revenues and large money managers need to move chucks of stock anonymously, dark pools seems set to continue to growth.

As the chess game between Wall Street and the SEC develops, it is always interesting to watch the way regulations and the response to them, often have greater unintended consequences than intended.

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