Lawmakers took up the often confusing topic of dark pools in a hearing Friday, and many appeared to come out of the hearing with no more understanding than what they had coming in.

Dark Pools

“I’m still trying to get my head wrapped around fractions of nanoseconds,” said Rep. Bill Huizenga (R-MI), working to understand the increasing speed at which algorithmic trading systems execute orders.  Nanosecond trading is typically associated with high frequency trading where decisions are made in a millisecond and occur on both regulated exchanges and dark pools to a lesser degree.

Lawmakers were playing “catch up,” said Rep. Stephen Lynch (D-MA) said in testimony “and it’s been a real struggle.”

Regulation National Market System (NMS) designed to make trading more fair for retail investors

Regulation NMS, or national market system, was initially designed to make trading fairer for average investors by allowing them to get the best price, among tackling other issues. Dark pool trading, conducted off exchanges by institutional firms, was typically non-transparent and conducted in private arenas.  Since Regulation NMS has been implemented, certain dark pool volumes have swelled.

Dark pool trading volumes spiking

As was noted in a ValueWalk article last week, trading on Citadel’s dark pool has exploded.  Citadel, which executes nearly 25% of all retail stock trades, saw its year over year dark pool volume increase by nearly 300%.  Currently 40% of all stocks are traded on dark pools, as opposed to exchanges.

Reg NMS was established nearly a decade ago with the idea to keep the U.S. competitive with worldwide financial centers who were embracing electronic technology at a much faster pace, as floor brokerage business fought to remain relevant in the US, exchanges in London, Frankfurt and Asia dove ahead into electronic trading systems.

Four components of Reg NMS

There are four components of Reg NMS:

An order protection rule works to ensure investors receive the best price.  Thus, orders are required to be routed around to exchanges electronically to achieve this goal.  This is significant as routing orders to an exchange or dark pool that provides rebates to brokerage firms is still an issue.

An access rule has the goal to improve access to quotations from all trading centers in the NMS system, including dark pools.

The somewhat controversial sub-penny rule set a quotation increment of all stocks over $1.00 per share to at least $0.01, which market makers have charged reduces their profit potential, forcing them into riskier strategies.

The market data rules allocate revenue to self-regulatory organizations, creating a self funding mechanism for regulation, unlike the CFTC, which relies on Congressional approval for funding.