SEC frowns on trading systems that keep investors in the dark

The Securities and Exchange Commission proposed on Wednesday new steps that could soon bring more oversight over private trading systems that go by the ominous sounding name of “dark pools.”

Dark pools are private trading systems that allow buyers and sellers of a stock to make transactions outside public markets. Instead of taking place on the New York Stock Exchange or some other public platform, such transactions occur as private deals between two parties.

When an everyday investor wants to buy or sell a stock, the transaction happens in a public setting on an exchange. However, information about orders made in dark pools is usually made available only to the limited universe of participants in the dark pool. Often dark pools share information with other dark pools, and private trading networks or alliances are formed.

This prejudices average investors, Securities and Exchange Commission Chairwoman Mary Schapiro suggested, because the information flow has been one way. She said that “these participants are able to use and rely upon the prices provided by the publicly displayed markets, without contributing information of their own.”

Since dark pools account for a growing portion of the volume of shares trading, average investors are being denied important market information.

The SEC proposes that indications of interest in a trade in a dark pool be made public, as is the case now with stock quotes.

“If you try to say that individual investors ought to have the same access to dark pools as, say, an IBM pension fund, you are going to take away a lot of the utility of this,” said Robert Pozen, chairman of Boston-based MFS Investment Management, which has more than $150 billion in assets under management. “That will basically undermine the whole utility of these dark pools.”

Stock exchanges, he said, are unable to process very large trades, and the dark pools serve an important function for large institutional investors, such as banks, insurance companies and pension funds.

Absent changes, the proposed SEC rules would take effect after a 90-day comment period.

The effort to shine light on dark pools is also part of a broader effort by the Obama administration to put in place what is sure to become the biggest revamp of financial regulation since the Great Depression.

Once an exotic alternative trading mechanism, dark pools, which trade large blocks of stock, are thought to account for more than 7.2 percent of the volume of all shares traded in the second quarter.

These pools involve massive trades that involve too many shares to be done easily on an exchange, and there’s scant public information about such trades.

“Given the growth of dark pools, this lack of transparency could create a two-tiered market that deprives the public of information about stock prices and liquidity,” Schapiro said before SEC members voted on three measures designed to improve transparency in dark areas of securities trading.

Dark pool traders are big participants in high-frequency trading, sometimes called flash trading, a practice by which big investors such as Goldman Sachs and others use lightning-quick orders and cancelations to discover price information about stocks faster than other market participants.

The SEC proposed last month to ban flash trading, and followed that up Wednesday with rules that could amount to a de facto ban on dark pools.

(c) 2009, McClatchy-Tribune Information Services.