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The Decoder: Dark Pools


Complex financial topics explained.

Editor's Note: Welcome to The Decoder, a regular series that will explain some of the more complex financial and business topics in the news. If you have a topic you'd like decoded, let us know in the comments.

The public-relations people for dark pools are probably wishing they'd come up with a better name. "Dark pools" sound sinister, suspicious, illicit and, well, dark. And that's not what Wall Street needs to win over the public in the wake of the credit crisis.

Indeed, dark pools are garnering lots of attention from regulators in both the US and Europe these days.

What exactly is a dark pool, besides something you don't want to dive into when snakes and other vermin might be swimming beneath the surface?

Dark pools are trading systems where large institutional investors can execute trades without the public market seeing them. They're legal, alternative stock exchanges that were created so traders could buy or sell a large block of shares without the broader market finding out before -- or after -- the trade was made.

For instance, if Goldman Sachs (GS) wanted to unload a large number of Microsoft (MSFT) shares in the open market at the best possible price, they'd have to go looking for potential buyers. In doing so, other traders would hear about the pending sale, potentially taking advantage of an opportunity to profit from it before the Goldman trade happened. Dark pools, where large buyers and sellers communicate anonymously without the broader market knowing, theoretically prevent front-running by other traders.

Investors like the anonymity of dark pools, and they also like their lower costs since they don't have to pay transaction fees to the exchanges.

Dark pools in one form or another have been around for more than a decade, but they've recently garnered attention from regulators as their volume has picked up. According to some estimates, 12% of the total trading volume in the US takes place in dark pools. They've also attracted more attention with high-frequency trading coming under scrutiny. So-called flash trades -- which are rapid-fire, high-volume trades based on algorithmic formulas -- have recently become a bigger part of dark-pool activity as the liquidity in them has improved.

Perhaps not surprisingly, these trading systems have their critics. Many of the largest dark pools are operated by the very Wall Street firms that use them. Goldman Sachs' Sigma X trading system became the biggest dark pool earlier this year. Others are owned by Fidelity Capital Markets, Citigroup (C), Deutsche Bank (DB), and Morgan Stanley (MS). Others, like Liquidnet, are independent, and still others are backed by the major stock exchanges, such as the NYSE Euronext (NYX). Many of these dark pools partner with each other, effectively creating one very large, very dark pool.

Regulators are desperately trying to figure out how to prevent another credit crisis, and dark pools are squarely in their sight. "Given the emerging risks posed by dark pools, the commission will be taking a serious look at what regulatory actions may be warranted," SEC chairman Mary Schapiro said this summer.

Right now, the SEC doesn't require transparency on trades that represent fewer than 5% of the total outstanding shares of any given stock. But with dark pools getting more volume, regulators are concerned that the lack of transparency could prevent average investors from finding the best available price for a trade.

A similar battle between dark pools and regulators is playing out in Europe, where about 15 such trading environments are doing a brisk and bustling business.

Dark pool operators argue that their systems help retail investors, since mutual funds are among the institutional investors that benefit from them. They're also quick to point out that if all of the large block trades were to take place on the open market, prices for all investors would be higher.

Many of the companies behind the biggest systems, including Goldman Sachs, have consented to greater transparency. They appear willing to come to the table with regulators for a conversation about the future of dark liquidity, as long as that future includes them in it.

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