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David Weidner's Writing on the Wall

Oct. 27, 2009, 12:01 a.m. EDT · Recommend (6) · Post:

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By David Weidner, MarketWatch

NEW YORK (MarketWatch) -- Transparency and fairness.

They are the two reasons Wall Street has always billed itself as having the greatest markets in the world. On the exchanges everyone puts their cards on the table and the winners win and the losers lose regardless of race, color, creed or connections.

It's simple and clean -- at least in theory. In practice, Wall Street's playing field has always been tilted toward a select few. The only things that change are the methods. Yesterday's trades done "upstairs" have been replaced by dark pools, off-the-exchange exchanges where big investors and traders go to trade anonymously, away from the prying eyes of the mom and pops, the Joe Six Packs and the investors who might benefit from the information those markets keep hidden.

Mary Schapiro

More than one out of every 10 stock trades takes place in a market where you or I and possibly even our brokers can't buy and can't sell. Dark pools are Wall Street's secret stock market, a place where big investors look to unload huge blocks of stocks without influencing the broader market or giving their identities away. In other words, exactly the opposite of one of the market's two pillars: transparency.

Surprisingly, the beleaguered Securities and Exchange Commission, which has failed to yield significant regulatory reform more than a year after Lehman Brothers' collapse, is finally getting aggressive about dark pools. Last week the commission voted 5-0 to move forward with new rules that would require some trades made in dark pools to be disclosed. See full story.

To be clear, the SEC is just proposing the rules, which means the industry will have ample time to water down the final rules or scuttle them altogether. And dashing the rules is far from a long shot. New rules aimed at curbing naked short selling of stocks -- an almost universally despised trading practice -- has actually stalled as Wall Street continues to amend and soften the final rules. See full story.

Still, it's encouraging that the SEC under its new chairman, Mary Schapiro, is even considering the issue given its lack of temerity in attacking high-frequency trading, flash trading, insider trading, capital levels at investment banks, fraud, asset quality, hedge fund regulation and Ponzi schemes in the recent past.

The dark pool problem is one the SEC can't ignore. Some dark pools have grown so big they are like private stock markets. The big three include Credit Suisse's /quotes/comstock/13*!cs/quotes/nls/cs (CS 54.26, +0.57, +1.06%) CrossFinder, Knight Capital Group Inc.'s /quotes/comstock/15*!nite/quotes/nls/nite (NITE 17.63, -0.26, -1.45%) Knight Link and Goldman Sachs Group Inc.'s /quotes/comstock/13*!gs/quotes/nls/gs (GS 178.58, -0.79, -0.44%) Sigma X. Together these "alternative trading systems," capture about 55% of all dark pool volume, according to Tabb Group.

Under one proposal, the SEC would lower the threshold for when dark pools must tell the public about the best prices their participants are offering to buy or sell shares. Under current rules, the disclosure requirement only kicks in when a dark pool accounts for 5% or more of the trading volume of a stock. The proposal would lower that to 0.25%. The requirement would apply if the dark pool is showing orders to more than one person.

Another proposal, and a better one, is subjecting all indications of interest to the same disclosure rules found in other markets.

It's a simple and fair rule which means it's under attack by a Wall Street afraid that it's going to lose its edge on the kind of investors who play inside the lines. Critics of the new rule take a defeatist stance that this is the way Wall Street has always been, so why change?

"There is essentially nothing wrong with matching or bettering the price of a public quote," Miranda Mizen of the Tabb Group wrote in a July 19 report. "Upstairs traders have been doing it since the invention of fire, and most dark pools price relative to the national best bid and offer."

Proponents of dark pools also argue that trades sent to the public marketplace are subject to trade talk. Traders find out about big orders and can hurt an investor looking to buy or sell a big block of shares. They argue that orders in dark pools are less susceptible to the gossip mill.

The problem, of course, is that bulky trades move markets. If I'm at Merrill Lynch and I need to unload 500,000 shares of XYZ, I can place the order in dribs and drabs -- through the multiple public markets out there including the Nasdaq, EDGE and Arca. But that order still is going to pressure XYZ's share price. Also, I'm going to be giving myself away.

It also means that XYZ's share price should be lower because there are more shares for sale than buyers. That's how free markets are supposed to work, right?

The bottom line is that if dark pools share information just like exchanges, then their order flow info needs to be made public, just like the New York Stock Exchange and Nasdaq Stock Market /quotes/comstock/15*!ndaq/quotes/nls/ndaq (NDAQ 18.71, -0.53, -2.75%) make their info public.

If they can see my trades, I should be able to see theirs.

Remember, transparency and fairness are what make Wall Street great. Or maybe the dark pools have something to hide?

David Weidner covers Wall Street for MarketWatch.

It is obvious that the USA has always had two sets of rules, fair and unfair.If you get a W-2 you are screwed, but if you are a corp you have every imaginable loophole available, offshore deals, under the table deals, "black pools," etc.It is hard to support any leadership in this country while they hold harmless the crooks at the heart of the economic problems, and turn their backs..."

- johnc19 | 12:57 a.m. Today12:57 a.m. Oct. 27, 2009

You can hardly blame U.S. consumers for feeling a bit down. Unemployment is rampant and looking to stay that way. Jobs prospects are lousy, there isn't much hiring going on. And with the winter holidays right around the corner -- a key time for retailers -- spending could dry up.

2:24 p.m. Today2:24 p.m. Oct. 27, 2009 | Comments: 6

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