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) -- Although the average retail investor views the floor of the

New York Stock Exchange

as the place for buying and selling stocks, in reality trading has exploded in private electronic markets owned and dominated by banks and brokerages like


(C) - Get Citigroup Inc. Report


Goldman Sachs

(GS) - Get Goldman Sachs Group, Inc. Report


Credit Suisse

(CS) - Get Credit Suisse Group AG Report


These exchanges are referred to as "dark liquidity" by market pros, denoting the fact that trading takes place outside the public arena. In dark markets, only the buyer and seller know how many shares were traded, when and at what price, as opposed to a publicly displayed "ticker" quote showing a stock's movement.

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Historically, dark liquidity has been considered an "alternative" market to the much larger public NYSE and Nasdaq; a clubby place for large institutional investors to trade free of those looking to profit off the price swings caused by large buy and sell orders.

But with public exchanges like

NYSE Euronext



Nasdaq OMX Group



CME Group

(CME) - Get CME Group Inc. Class A Report

planning to consolidate or buy each other out, these once alternative trading venues are becoming more mainstream and could force the

Securities and Exchange Commission

and other regulators to take steps to push trading back into the light.

Calls for comment from on dark pools and alternative venues from the NYSE and Nasdaq were not returned.

"Once alternative markets start getting even bigger, regulators are going to start thinking of ways of getting this order flow back into the public markets," says Larry Tabb, founder and CEO of market consulting firm Tabb Group. "Now that that we have a third of order flow matched in the dark, there is even a greater chance of that happening."

Dark liquidity and alternative trading are nothing new to Wall Street. In fact, the practice has been around for decades. The first electronic communications network, Instinet, was founded in 1969 as a way for brokers to trade shares outside the traditional exchanges.

But it was the creation of the SEC's Regulation National Market System (NMS) in 2001 that jump-started private exchange growth to new levels. Ironically, the goal of the rule was to promote competition with the NYSE and Nasdaq, according to Tabb.

"With Reg NMS, there was a huge pickup in electronic trading because it lowered the economics," Tabb explains. "The regulators wanted to promote competition with the exchanges, and it became easier and cheaper to match buyers and sellers."

In the years following the rule, banks and brokerages quickly scrambled to set up their own dark pools and alternative trading platforms. Some of the largest and most successful have been run by banks, including Credit Suisse's CrossFinder network, Citigroup's CitiMatch and Goldman Sachs' SigmaX.

The goal, according to the banks, is to create private exchanges for their largest clients to sell millions of shares of stock without having to worry about smaller traders "front running" them, or using electronic hacks to purchase or sell shares when a large order could potentially move the price.

The mutual fund industry made that point clear in a recent letter to the SEC on the regulation of dark markets. "

The confidentiality of information regarding fund trades is of significant importance to Institute members," the mutual fund trade group Investment Company Institute said in the letter. "Any premature or improper disclosure of this information can lead to front running of a fund's trades, adversely impacting the price of the stock that the fund is buying or selling."

However, as time progressed and more dark pools and alternative markets were created, many banks and brokers realized that they could gain a hefty profit from running their own trades rather than routing them through the NYSE or Nasdaq.

The result is that dark pools have wrestled away a significant amount of trading volume, 13.3%, from public exchanges for U.S.-listed shares, according to a report by Rosenblatt Securities. Added to other alternative trading practices, such as "internalizing" trades between market makers, and more than a third of all equity trading -- and a majority of retail orders -- now take place in private trading where there is little information about the price of stocks.

Added to the mix has been the entrance of high-frequency trading firms that have set up dark pools as their private playgrounds. These firms often pay larger investors for "order flow," rebating fees or straight up writing a check in order to build up their markets and trade off the liquidity.

"Not all dark pools are created equal," says Richard Repetto, principal with Sandler O'Neill in New York. "Some are created to allow big-size trades into the market without moving it. Others are created as a way for brokers to pool their trades and keep those fees off the public markets."

The end result has been a rapid change from a market dominated by a few large public exchanges to scores of small private markets.

"Often incumbent exchanges have lost gobs of market share to rivals owned not by shareholders but rather by high-frequency traders and brokers, who derive significant strategic benefits from operating these exchanges and do not always push to maximize profit generated by these platforms" a report issued by Rosenblatt earlier this month.

Draining the Pools

The question for many in today's stock market is whether the SEC can rein in the dark market monster it created by deregulating the exchanges.

Dark pools and alternative trading platforms continue to have their place for investors, says Ari Burstein, senior counsel in ICI's securities regulation/capital markets group. 

"Arguably dark pools perpetuate the fragmentation of the equity markets, but they allow mutual funds investing on behalf of shareholders to interact without some of the concerns about the predatory order flow that is sometimes found in the public markets," Burstein said. 

Burstein added that ICI generally supports encouraging dark market owners to display prices from their trades into a public forum. But even that would need to be limited, he argues, since any immediate displays of prices and identities of dark pools where trades occurred would allow firms to front run large investor trades. 

"Price transparency should be encouraged, as long as it's clear benefit to retail investors," Burstein added.

Several regulatory solutions are being considered by the SEC to get better transparency around dark markets, although industry professionals agree that wholesale changes or outright banning some practices is unlikely.

One solution was floated last week when a special SEC report was issued on the May 6, 2010, "Flash Crash." A suggestion included new rules and incentives for traders in dark markets to continually post quotes close to market prices.

Separately, an eight-member committee urged the SEC to adopt the "trade-at rule," which would prevent brokers from executing orders in dark liquidity without "price improvement" when compared to the public markets.

"While such a routing regime provides order execution at the current best displayed price, it does so at the expense of the limit order posting a best price which need not receive execution," the committee's report said. "An alternative framework is a 'trade at' regime in which orders must be routed to one or more markets with the best displayed price."

Whatever the solution, Tabb believes that the public exchanges like the NYSE and Nasdaq should not just rely on regulators to step in and save their old business model.

"The exchanges need to combine to create scale. They need to move into other asset classes and geographies," Tabb says. "There will be more exchange consolidation, you will see new dark pools and alternative platforms. The brokers will continue to match up as much liquidity as possible outside the exchanges."


Written by Christopher Westfall in New York.