Dark Pools Threaten Market Governance of Financial Markets

Today’s markets comprise a fragmented network of 12 national exchanges and around 37 active, non-exchange trading platforms, or “dark pools,” competing to attract share trading to their venues, said Yesha Yadav, associate professor of law, in her new paper The Governance Gap in Fragmented Markets. Dark pools delay reporting of large transactions, making them feasible without affecting the market during the transaction.

Exchanges provide access to an important economic asset – a forum for buying and selling securities. They are ideally positioned to monitor and discipline the public companies that raise capital by listing their securities on an exchange as well as the traders that come to an exchange to buy and sell these securities.

Regulators have long relied on exchanges to police listed companies and securities traders to make sure they meet basic corporate governance standards, comply with securities rules and follow industry best practices. Were that not the case, investors would be left to deal with this burden on their own, and would likely spend less on investments and more on protecting those investments. This oversight role made sense when NYSE, NASDAQ and other major exchanges saw most of the secondary trading in the shares that listed on their platforms, Yadav said. For example, the NYSE once handled as much as 80 percent of all secondary trading in its listed securities. But with this number down to around 20 percent in the era of dark pools, the regulatory function that exchanges are supposed to perform has become a costly burden.

Exchanges now face two major problems. First, they get lower revenues from trading, owing to competition from nimble, less-regulated dark pools. But the cost of governing is higher. Fragmentation makes it harder and more expensive for exchanges to collect and analyze information from across the system of almost 50 or so trading venues. This leaves more room for misbehaving traders to utilize the information gaps created by fragmentation for pursuing disruptive strategies. Second, lower revenues and higher competition can intensify the conflict of interest already present in a regulatory system that relies on for-profit exchanges to discipline traders that are their major sources of business. This can make exchanges less motivated to govern strictly, especially if they pay a price by losing future business to other exchanges or dark pools.

“While fragmentation may have brought benefits in the form of lower fees and many options for investors, it has also extracted a heavy price from the system as a whole,” Yadav said. “Exchanges are deeply diminished in their ability to effectively regulate markets. Lower revenues, fierce competition and increased incentives to take profitable risks have placed venues on the back foot in their ability to oversee an innovative, sophisticated and constantly mobile market. The cost is ultimately paid by investors, public companies, and by the market that can no longer rely on the protective oversight of exchanges to allocate capital.”

To fill this “governance gap,” Yadav proposes the creation of a new liability regime for exchanges and dark pools for governance failures. Traditionally, exchanges have enjoyed fairly extensive legal immunity in the performance of their regulatory goals. With fragmentation eroding incentives for good governance, stronger legal liability for both exchanges and dark pools will force risky trading platforms to pay for their supervisory failures. In addition, Yadav proposes the creation of a new liability fund, financed by exchanges and dark pools, to pay out to investors in case of losses caused by the failure of these trading platforms to provide effective oversight.

“This new liability fund would help hold exchanges and dark pools more fully liable for governance failures,” Yadav said. “The goal is to encourage robust self-monitoring between venues and create economic skin in the game for everyone, aligning their incentives to better conduct good and effective governance in the marketplace.”