Dark Pools Grow as Wall Street Eyes Regulation
Trading in dark pools - equity trading systems that do not publicly display orders - has continued to grow in recent years despite decreasing volumes on open exchanges.
U.S. regulators have declared they are stretching their oversight to include the opaque trading vehicles, which many have blamed for the declining trading volumes seen in 2012.
These non-display and over-the-counter trades rose to 33 percent of total U.S. equity volumes in 2012, according to Rosenblatt Securities, up from 30 percent the year before. And the number has risen 50 percent over the last three years, according to the CFA Institute.
But proponents argue that dark pools are actually benefiting open exchanges.
"The more fundamental thing to look at is, in terms of dark pools, why do people use dark pools? A, they create value and b, they facilitate a very efficient investment process," Per Loven, the head of international corporate strategy at Liquidnet Europe told CNBC Tuesday.
The global trading network deals with 700 asset managers, mutual funds, pension funds and hedge funds and Loven says that the amount of shares these funds have to deal with is not proportional with the open exchanges. There's a supply and demand imbalance when an institution wants to implement an investment decision, according to Loven, and pushing that liquidity in an uncontrolled way onto an open market creates volatility which is not good for the market.
"The average institutional-sized order in the U.S. is about 250,000 shares. The average execution size on the exchanges and on most of the other dark pools (excluding Liquidnet) is about 250 shares. This imbalance explains why it is so difficult for institutions to get trades executed," Liquidnet said in a research note.
Haoxiang Zhu, an academic at Massachusetts Institute of Technology, wrote a thesis in November on the subject, finding that dark pools can have their merits and are an "important part of equity market structure".
When trading on information dark pools lose their shine, according to Zhu, as investors sometimes can't complete orders quick enough. Therefore, informed traders are more likely to use open exchanges and brokers are receiving more precise bids because of it.
"Adding a dark pool alongside an exchange tends to concentrate price-relevant information into the exchange and improve price discovery. Improved price discovery coincides with reduced exchange liquidity," he said.
"I'm a strong believer in perfect information in markets. There shouldn't be two classes of investors in a perfectly functioning market," Carl Weinberg, chief economist at High Frequency Economics told CNBC Tuesday.
(Read More: High-Frequency Trading: It's Worse Than You Thought)
Several media reports last week said U.S. regulators have been eyeing up the trading venues as well as high-frequency trading (HFT), which uses software to post trades in microseconds.The latter has been blamed for a number of glitches on global stock markets over recent months.
Financial Industry Regulatory Authority (Finra), a Wall Street regulator, has announced that it will take measures to widen its investigations to include these operations, as well as controversial HFT and wash trades, a move that Loven concedes that is the right move.
"I think it's good to have an overhaul in regulation in general," he said.
"The market may need to change in a certain way and we very much welcome that."