Dark Pools of Liquidity

Corporate Finance

A Presentation by:

How Dark Pools of Liquidity Work and their effect on the U.S. Financial System

John AbbottSamia BagdadyKunal Bavishi

Andre SanchezTodd Vivenzio

Dark Pools of LiquidityBackgroundWhat are Dark Pools? When Did they Arise?

• Dark Pools of Liquidity are ways that investors/financial Institutions can hide their orders

• Has existed for a while, just under different names• “Upstairs Market” at NYSE• Black Pool• Alternative Trading System (ATS)• Crossing Networks

• Became very popular in the 1980’s• Rise in computer use facilitated “Dark Pool” growth

Dark Pools of LiquidityBackgroundWhat are Dark Pools? When Did they Arise?

• Unlike the “Open” NYSE Exchange, “Dark Pools” draw price from market

• “Dark Pools” do not impact the market price

• Details of transactions do not have to be reported to market

• Becoming increasingly popular among Hedge Funds and Brokerage firms

• Sell large positions anonymously• Strategic edge over firms that trade

large volume in open market

Dark Pools of LiquidityBackgroundWhat are Dark Pools? When Did they Arise?

How much are Dark Pools of Liquidity Growing?

Percent of Total Equity Trad-ing Transactions (2007)

ATSOpen Market

10%

90% 2006 2008 2010 2012 20140%

20%

40%

60%

Growth of "Dark Pools" in Equity Markets (Projected)

ATS T

rades

Tota

l M

ark

et

Com

posit

ion

Only Comprise 10 % of Equity Trading……but are growing at an enormous rate (40%!)

Dark Pools of LiquidityBackgroundWhat are Dark Pools? When Did they Arise?

• What are the Main Drivers for “Dark Pool” Growth?• Main role was to provide a “crossing network” to match sellers/buyers• Now biggest drivers are…

• Speed Trading• Algorithms• “Sharing of Dark Pools”• Locking out other firms and individual traders…ethical?

Dark Pools of LiquidityUses of Dark Pools of LiquidityHow are they used? What are their advantages? What are ATSs?

• Normally, equities are exchanged on open markets • NYSE• NASDAQ

• This presents several disadvantages to sellers• “Open Market” = Lack of privacy• Technical Pressure

• Large # Shares Sold• Broken into Blocks• Higher Supply, Lower Price

50,000shares

10,000

shares

10,000

shares

10,000

shares

10,000

shares

10,000

shares

2$/share

Time

1$/share

Dark Pools of LiquidityUses of Dark Pools of LiquidityHow are they used? What are their advantages? What are ATSs?

•Dark Pools are Closed Exchanges•Also called ATS (Alternative Trading System)

• Buyer & Seller = Anonymous• Don’t have to Break up shares

• As a result, faster trading• Cheap for sellers! 0.5 - 2¢/share

50,000shares

10,000

shares

10,000

shares

10,000

shares

10,000

shares

10,000

shares

Dark Pools of LiquidityUses of Dark Pools of LiquidityHow are they used? What are their advantages? What are ATSs?

0%

10%

20%

30%

40%

50%

60%

70%

80%

200775% of Equities

Traded on Open

Markets

201162% of Equity

Traded on Open

Markets

ATS Impact on Open Market Equity Trading1

Perc

ent

of

Equitie

s Tra

ded o

n

Open M

ark

ets

(N

YSE, N

ASD

AQ

)

Figure 1.1 – ATS Impact on Open Market Equity Trading1Source: Aite Group Independent Research, 2007

• Traditional exchanges have grown worried

• “Dark Pools” (ATSs) have funneled away business

• NASDAQ/NYSE have forged partnerships with foreign exchanges

• Also purchased smaller ATS exchanges

Dark Pools of LiquidityUses of Dark Pools of LiquidityHow are they used? What are their advantages? What are ATSs?

No. of Dark Venues

Source: TABB Group Estimate

18 27 32 45 52 533 4 9 21 29 36

1.5%

4%

7%7.

5%

12.5

%

1%2% 2%

3%

5%

10%

11.5

%

2005 2006 2007 2008 2009 2010

US Europe

% Traded Volume(dark)

Dark pools are steadily gaining market share in both the US and Europe

• Although studies don’t agree on the %age, they all agree “dark pools” are growing• Domestically and Globally

Dark Pools of LiquidityPotentials for AbuseDo Dark Pools have potential for Abuse? Have they been abused?

• Lack of Transparency = Lack of Regulation• Lack of Regulation = Abuse?• Open markets work with the SEC

• Cooperation occurs to Investigate potential abuses/fraud

• SEC can fine…heavily• SEC fined NYSE/Nasdaq

$8.25 million…for failure to keep emails

• Gives SEC leverage with regards to regulating/implementing rules in open markets

Dark Pools of LiquidityPotentials for AbuseDo Dark Pools have potential for Abuse? Have they been abused?

• In closed markets (ATS’s), there is little to almost no regulation• Buyers & sellers essentially, regulate themselves

• Can we really trust large fund managers to regulate themselves?

• “Why regulate when were making money?”

Dark Pools of LiquidityPotentials for AbuseDo Dark Pools have potential for Abuse? Have they been abused?

• Recent years financial modeling and computerized high volume fast paced trading have changed the marketplace• In a closed exchange, this could lead to abuse• Primarily, Pricing arbitrage

ar·bi·trage [ahr-bi-trahzh] –noun the simultaneous purchase and sale of the same securities, commodities, or foreign exchange in different markets to profit from unequal prices.

Dark Pools of LiquidityRegulations regarding Dark PoolsAre Dark Pools Regulated?

• Dark Pools lock out the “little guy”!• People who don’t buy in large blocks• Individual Traders• Is that really fair?

• Regulation changes depending on country

• Asia• Dark pools put on

open exchange• Europe

• MTF by UBS• immediate post

trade data available

Dark Pools of LiquidityRegulations regarding Dark PoolsAre Dark Pools Regulated?

• What about the United States?• SEC is enacting new regulations to tackle unfairness which arises due to ATS use in 3 ways…• Amending the definition

of “bid or offer”• Lowering the trading volume threshold that triggers the ATS order display• Changing the existing joint-industry transaction reporting rules to require post-trade disclosure of the identity of the dark pool on which each trade is executed.

Mary Schapir

oSEC Chair

Dark Pools of LiquidityRecommendationsHow Should Dark Pools be regulated? What do we think?

• Ultimately what began as a “support” system for investors trying to unload large numbers of shares, has become something entirely different• Essentially, we know have a two tier marketplace

• A market for low volume trading that is open and regulated

• Another market where large firms can trade huge amounts of shares with little to no regulation or oversight

• Dark pools can potentially be a systematic risk…• Disclosure is essential in a global marketplace

Dark Pools of LiquidityRecommendationsHow Should Dark Pools be regulated?

Questions?

Thank You!