Over the past years, traditional equity exchanges have decreased due to consolidation in the market. On the other hand, alternative trading systems (ATSs) have merged as a second medium for trading [8]. Today, there are over 40 such ATSs compared to only 11 exchanges [9]. ATSs can be separated into electronic communication networks (ECNs) and dark pools [5]. In line with the increasing number of ATSs, dark pool trading activity has increased substantially. In 2009, the percentage share of total equity volume traded in dark pools in the U.S. amounted to 25% and has since increased to 35% according to the SEC. While dark pools claim to offer many benefits to its participants, a recent surge in fines and penalties from the regulator against operators of dark pools has renewed the debate whether dark pools actually contribute to the overall quality of the market.
Players in the dark pool segment
In general, dark pools attract a variety of participants. The main advantages dark pools claim is to provide traders with additional liquidity, lower submission and execution fees and due to its nature of not publicly displaying orders, a limited effect on the market when trades are executed [7]. On the flipside, there are various issues to consider relating to market fragmentation, equal access, price formation and manipulation and potentially improper trades that are relevant to the different players [5].
Buy-side
Institutional investors such as those represented by the Investment Company Institute in the U.S. heavily depend on well-functioning capital markets as they had more than $13 trillion invested in U.S. equity for a total of 29 percent of publicly traded equity in 2011 [11]. These institutional investors are attracted to trading in dark pools, because of their feature of not disclosing prices until after a trade occurred. Routing orders through a dark pool should thus not move the market [5]. In reality, this theory does not always hold. High frequency traders have taken advantage of these investors and have front-run them on many occasions [12]. While the average transaction costs for larger block trades have substantially decreased [1], the buy-side has been the most vocal advocate for more market fairness as it bears most of its costs.
Sell-side
By setting up their own dark pools, sell-side institutions can cater directly to their client’s trading needs. They can then internally match up orders and, instead of paying other trading platform operators, save on trading fees [18]. In addition, the brokers can charge traders an access fee to their pools in a process called indirect internalization [5]. Nevertheless, as recent developments show, the legal and reputational liabilities for operating dark pools appear to be increasing. So much so that banks like Citi and Wells Fargo have or will shut down their ATSs due to “extra scrutiny from the regulator and the media” according to a trading executive quoted in the NY Post [4]. With trading volume already low, sell-side providers could soon pull out by the numbers as the cost of doing business outweigh the benefits. The fact that Barclay’s trading volume in their dark pool collapsed after they were caught lying about the access of high-frequency traders to their pools leaves a bad taste behind, as it appears that sell-side operators really did benefit from allowing predatory trading at the expense of their clients. Should sell-side operators continue to close their pools, the market will likely be left with less liquidity provided by high-frequency traders, but at the same time, price formation should improve for the benefit of retail investors.
Trading facility providers
Aside from broker-dealer owned dark pools, there are agency-broker, exchange owned and independent providers of ATSs. Agency-broker and exchange owned providers share a similar incentive profile with sell-side providers. High-frequency traders such as Getco on the other side are electronic
