Regulating Innovation: High Frequency Trading in Dark Pools
The Journal of Corporation Law, Vol. 42(4), 2017
54 Pages Posted: 16 Oct 2017
Date Written: October 3, 2017
Federal statutes regulate risk-taking by financial market intermediaries including the broker-dealers who execute trades and the securities exchange and clearinghouse platforms where trading occurs. For almost a century, these statutes have enforced norms that encourage disclosure, transparency, and fairness. In modern markets, innovation, and technology challenge these core principles of regulation. The engineering of computer-driven automated trade execution, the development of algorithmic trading, and the introduction of high frequency trading strategies accompany a number of important shifts in financial market intermediation.
First, a universe of private trading platforms known as alternative trading systems (ATSs) increasingly compete with and displace conventional exchanges. ATSs include a small group of platforms known as “dark pools” that engender critical benefits. Dark pools mitigate information leakage, enabling institutional investors to execute large block trade transactions without fear that imitators will replicate or that predators may prey on their trades.
Second, dark pools intermediate trading with limited regulatory oversight. These private pools function in a manner similar to conventional securities exchanges and clearinghouse platforms; yet, dark pools are subject to a lighter-touch regulatory framework. As a result, hidden dark pool trades enjoy reduced regulatory, compliance, and transaction costs. Unsurprisingly, the volume of dark pool transactions has grown exponentially, eclipsing conventional trading venues’ market share and redefining the balance of power in the financial market ecosystem.
Third, fragmentation has fractured trading markets. The transition from a small body of actors with quasi-monopolistic power to a diverse body of trading venues challenges antiquated notions regarding financial intermediaries’ role in facilitating price discovery, identifying market manipulation, and employing best practices for ensuring fairness and protecting the integrity of financial markets.
This Article argues that gaps in governance, contentious conflicts of interest, and increasingly intense fragmentation in trading markets create a growing source of underexplored concerns. An examination of the current regulatory framework reveals noteworthy perils including the potential for high volatility and significant market disruption. These concerns necessitate exploring ex ante the various enforcement measures, regulations, governance protocols, and information gathering tools already employed in markets to mitigate systemic risk concerns. This Article cautions regulators and commentators to emphasize dynamic, sustainable macroprudential regulatory solutions.
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