Financial markets regulation: The tipping point

Venkatachalam Shunmugam

18 May 2010



While over-the-counter markets for collateralised debt obligations and credit default swaps are blamed for the financial crisis of 2007-2009, what has been overlooked is the menace of rising opacity in the exchange-traded market. This raises questions about the fundamentals of this market’s very existence, i.e. transparency and equal access to one and all in the price discovery process.

Traditionally, trading in securities had been executed in pits as a central location (Gorham and Singh 2009), with traders exchanging buy and sell orders on their own or on behalf of their clients. In that system, personal interactions bred collusion among unscrupulous traders to front-run their competitors (Schlegel 1993). Front-running refers to an illegal practice of executing orders on a security early with the advance knowledge of pending orders from customers/competitors. Computerisation helped to eliminate front-running, and was better able to handle rising volumes, reduce transaction costs, and improve speed and accuracy. Naturally, the bulk of trade shifted to the online platform. What happened next? To attract volumes amid increasing competition, increased technology support and reduced delays became the fashion for online exchanges the world over.

Technology unlocks the door

Online trading threw markets wide open to all armed with a desktop and access to a public network. It brought in the much-desired transparency, as trading activities became visible through real-time price dissemination. The market order book – at least in terms of the best buy and sell orders and their respective quantities – could be viewed by participants. Soon, technology took over human involvement to change the way trading was done.

The start of “informal trading”

While exchange-traded securities markets had been struggling to build the much needed width and depth, large institutions that could have provided the same found comfort in the absence of a regulatory framework monitoring trades happening among them. No wonder, they were tempted to start an informal electronic trade matching and settlement system, later termed “dark pools”. This not only denied exchange-traded markets the necessary depth and width but also kept out well-researched information that these institutions could have brought in to make price discovery more efficient (Krause 2008). In essence, what was started as an “informal trading system” for a handful of big entities with vested interest became a business opportunity of matching, clearing, and settling trades and front-running the information that gets pooled into the system with them being the owners, managers, and traders themselves. Liking by what they saw, many more large institutions joined the bandwagon, substantially raising the tally of dark pools and trade handled by them (Caplan et al. 2009).

According to the Securities and Exchange Commission, the number of active dark pools dealing in stocks on major US stock markets trebled to 29 in 2009 from about 10 in 2002. For April to June 2009, the total dark pools volume was about 7.2% of the total volumes of all US exchanges.

What is so dark about dark pools?

Dark pools are a private or alternative trading system that allows participants to transact without displaying quotes publicly. Orders are anonymously matched and not reported to any entity, even the regulators (Younglai and Spicer 2009). Thus, the mainstream exchange-traded market does not have any clue about the volume of transactions happening in this parallel market or the prices at which they are being executed. Obviously, price discovery on the mainstream market, without dark pools information, becomes inefficient. Moreover, transactions carried out in dark pools effectively become over-the-counter in nature as the prices are not reported and financial risks not effectively managed. More critically, these risks can spread like wild fire as we saw in collateralised debt obligations and credit default swaps markets.

With no clear dividing line between the ownership, management, and participants in these markets, they are more prone to mismanagement and malpractices. Greed, competition, and incentives drive their business – these markets remain opaque and inefficient. Dark pools defeat the very purpose of a fair and transparent market participated by a large number of heterogeneous participants with diversified information converging on its platform. This fragmentation with some markets accessible to a privileged minority and others used by a vast majority can only be detrimental to healthy evolution of markets.

No wonder, experts think that dark pools can, anytime, blow splinters of systemic risks into the global economy, very much like how the sub-prime lending-induced contagious risks reared their ugly heads to trigger the largest financial crisis since the Great Depression.

According to reports (Younglai and Spicer 2009), a surge in the dark pool volumes in US markets is giving the Securities and Exchange Commission sleepless nights. The regulator has reportedly been planning to bring them into the mainstream. Its proposals, if implemented, will require dark pools to make information about an investor’s interest in buying or selling securities public. Clearly, an attempt has finally been made to bring “dark” transactions under a regulatory scanner through accountability. For post-trade transparency, the Commission has also proposed that dark pools publicly announce trades happening on specific platforms. What remains to be seen is measures being taken now and in near future to make these markets increasingly streamlined and to prevent them from becoming systemic risks. This will require standardisation of their operations and risk management procedures as well.

Flash trade – a privilege to a handful

Flash trading is a two-pronged strategy using superior technology and the privilege of a minority of traders to “flash trade”. This allows them to assess markets so that their algorithms can catch the reaction of mere mortals to take advantage of the overall market sentiment.

As it becomes mass produced or serviced, the technology is expected to be affordable for all. But we have to wait to see this really happening. Some propose there is nothing really wrong if an organisation that pays for reducing delays seeks returns to it. As algorithmic trading becomes mass produced and adopted, and also trusted by common investors to leave their hard-earned wealth to software programmes running on sophisticated hardware to multiply, it may set aside human inability to see between a second unlike the machine that can see the orders being punched into the system with a difference of a few milliseconds and help common investors reap the benefit that a privileged few have been enjoying.

But what is unacceptable is the practice of allowing a privileged minority to flash trade to track the reaction with high-speed processing capacity and the algorithm that can take advantage of the reaction to reap benefits – as this is akin to front-running. It is an example of high-frequency trading system with knowledge of asymmetric information that confuses common investors by simultaneously issuing and cancelling orders and entices them to shell out more for a particular security and, thus, squeezes out their profits.

It was the Chicago Board Options Exchange which pioneered flash orders early this decade to increase its execution speed (Patterson et al. 2009). Flash orders remained in the dark until a newspaper report in 2009 blew the whistle on how Goldman Sachs had made a killing through this route. According to Rosenblatt, flash trading accounted for about 2.4% of the total US stock volumes in June 2009.

In fact, high-frequency trading was designed to make markets more efficient through liquidity augmentation, but its use for flash trade can defeat this purpose by misdirecting markets. This practice, which enables (still) unregulated hedge funds to employ high-frequency strategies without coming under the view of US regulation as applicable to brokers, also puts a big question mark on systemic stability of the financial system. Liquidity is important indeed. But can “chasing liquidity” at the expense of transparency and fairness be healthy for market growth?

Market innovations for “forward mutation” and not “reverse mutation”?

Market innovations such as dark pools and flash trade that evolved to circumvent the limitations of exchange-traded markets involve systemic risks like the ones of sub-prime lending that caused the financial crisis.

Moreover, they can defeat the very purpose for which markets were created, i.e. to deep root capitalism to help businesses de-risk their margins from information that moves prices in the marketplace. These practices have also placed a barrier in front of markets wishing to function as a level-playing field for participants ranging from large institutions to seasoned traders to small investors.

There is a pressing need for formulating appropriate regulations to stop all practices that offer a privileged minority an unfair advantage over a vast majority of general market participants. Allowing a natural evolution of markets and discouraging the ‘mutated evolution’ that these market innovations represent needs to be one of the regulatory priorities.

If flash traders are allowed to get away with their continuous mutation of markets, what purpose is this evolution (of online markets) serving? This only points to a self-defeating weakness of markets – the recent financial crisis has amply demonstrated how fragile the global financial system can be. Unfair practices like dark pools and flash trade erupting in the supposedly organised marketplace can only add to this fragility. The question is: how long will it be before these unfair practices are stopped from destabilising markets and destroying their efficiency?

Markets are essential support institutions for the economic evolution of humankind. Can policymakers afford to allow the creation and continuation of mechanisms that can – at any time – destroy these institutions and make the public turn against the wisdom of capitalism?

Disclaimer: Views expressed here are personal.


Caplan, Keith, Robert P Cohen, Jimmie Lenz, and Christopher Pullano (2009), “Dark Pools of Liquidity”, PriceWaterHouseCoopers, Alternatives Newsletter.

Gorham, Michael, and Nidhi Singh (2009), Electronic Exchanges: The Global Transformation from Pits to Bits, Elsevier.

Krause, Reinhardt (2008), “Dark Pools Let Big Institutions Trade Quietly, Investor's Business Daily.

Patterson, Scott, Kara Scannell and Geoffrey Rogow (2009), “Ban on Flash Orders Is Considered by SEC: Schapiro Sees Inequity While Exchanges Wrestle for Market Share in High-Speed Trading”, The Wall Street Journal, 5 August.

Schlegel, Kip (1993), “Crime in the Pits: The Regulation of Futures Trading, American Academy of Political and Social Science

Securities and Exchange Commission (2009a), “SEC Issues Proposals to Shed Greater Light on Dark Pools”, October 21.

Securities and Exchange Commission (2009b), “Strengthening the Regulation of Dark Pools”, SEC Open Meeting, October 21.

Younglai, Rachelle and Jonathan Spicer (2009), “US SEC says "dark pools" are emerging risk to market”, Reuters, 18 June.



Topics:  Financial markets Global crisis

Tags:  financial markets, financial regulation, derivatives, dark pools

Chief Economist, Multi Commodity Exchange of India Ltd., Mumbai