Thursday, October 22, 2009

The SEC Dark Pool Proposal Will Increase Volatility And Decrease Liquidity

The SEC issued a proposal to require more disclosure from dark pools.

Of course, the issue is, will the SEC proposal reduce or increase liquidity and price volatility. Additionally, what will be the unanticipated consequences of the SEC's action?

The existence and growth of dark pools shows that there are economic gains in lower transaction costs (in the broad sense that include search and public disclosure costs) to both the seller and buyer users of dark pools.

Lower transaction costs increases the frequency of trades, decreases price movements per transaction, and increases trading volumes. More trades increase the transmission of new information into the price even if the first trades are in the dark pools. Dark pools are not a closed system. The participants also trade in public exchanges and transmit information from dark pools to public prices and vice versa.

Dark pools also enable a buyer to pay more and a seller to receive less because the economic gains from trade prices need not be adjusted for the higher public exchange transaction costs. Effectively, a wider band around a given price is created where a transaction will occur, making it more likely that a trade will occur at a desired price in dark pools.

Since a dark pool avoids real-time public disclosure of price, volume, identity, and dark pool, there must be an economic gain or a reduction in costs to the participants in not revealing their transactions. The SEC proposal will remove this economic benefit and impose a cost on dark pool participants, which will lower trading frequency and volumes.

The proposal will decrease liquidity of shares, which are also actively traded in dark pools, raise the costs of incorporating new information into the pricing of shares, narrow the price band where trades will occur, and increase transaction price volatility of shares.

The open question is how high the extra cost of disclosure will be and to what extent will it affect dark pool and public exchange trades.

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