Advances in technology have drastically changed how investors buy and sell securities. Driven largely by the increase in demand for the ability to execute high frequency trading (HFT) strategies, traditional securities exchanges are being displaced by alternative trading systems (ATS). These ATS offer investors several advantages, including improved execution and the ability to trade away from a public exchange using anonymous indications of interest. The rapid pace with which these systems are developing has presented regulators with a significant challengeto try and create a workable regulatory regime to monitor trading in a highly fluid, increasingly complex environment. This is especially so given that the scale of trading on these ATS amounts at times to as much as 15 percent of all securities trades in the United States.
One ATS that has recently come under regulatory scrutiny is known commonly as a “dark pool.” It is estimated that there are about 50 dark pools currently in operation.1 Dark pools allows investorsprimarily mutual funds and other institutional tradersto trade large blocks of securities in a manner that prevents high-frequency traders from front-running their trades and thus move the market in such a way that makes it difficult to finish the initial trade. Specifically, counterparties to a trade in a dark pool are anonymous to each other and treat the ATS as the counterparty. This allows for the price quotes of the securities to be traded to remain confidential. The value of trading in dark pools, then, is that it permits large institutional investors to maximize profits by being able to execute a trade without the fear of having that trade front-run by a high-frequency trader.
