1. Corporate Finance A Presentation by: How Dark Pools of Liquidity Work and their effect on the U.S. Financial System John Abbott Samia Bagdady Kunal Bavishi Andre Sanchez Todd Vivenzio

2. Background What are Dark Pools? When Did they Arise? Dark Pools of Liquidity are ways that investors/financial Institutions can hide their orders Has existed for a while, just under different names “Upstairs Market” at NYSE Black Pool Alternative Trading System (ATS) Crossing Networks Became very popular in the 1980’s Rise in computer use facilitated “Dark Pool” growth

3. Background What are Dark Pools? When Did they Arise? Unlike the “Open” NYSE Exchange, “Dark Pools” draw price from market “Dark Pools” do not impact the market price Details of transactions do not have to be reported to market Becoming increasingly popular among Hedge Funds and Brokerage firms Sell large positions anonymously Strategic edge over firms that trade large volume in open market

4. Background What are Dark Pools? When Did they Arise? How much are Dark Pools of Liquidity Growing? 90% Only Comprise 10 % of Equity Trading……but are growing at an enormous rate (40%!)

5. Background What are Dark Pools? When Did they Arise? What are the Main Drivers for “Dark Pool” Growth? Main role was to provide a “crossing network” to match sellers/buyers Now biggest drivers are… Speed Trading Algorithms “Sharing of Dark Pools” Locking out other firms and individual traders…ethical?

6. Uses of Dark Pools of Liquidity How are they used? What are their advantages? What are ATSs? Normally, equities are exchanged on open markets NYSE NASDAQ This presents several disadvantages to sellers “Open Market” = Lack of privacy Technical Pressure Large # Shares Sold Broken into Blocks Higher Supply, Lower Price 50,000 shares 10,000 shares 10,000 shares 10,000 shares 10,000 shares 10,000 shares 2$/share Time 1$/share

7. Uses of Dark Pools of Liquidity How are they used? What are their advantages? What are ATSs? Dark Pools are Closed Exchanges Also called ATS (Alternative Trading System) Buyer & Seller = Anonymous Don’t have to Break up shares As a result, faster trading Cheap for sellers! 0.5 - 2¢/share 50,000 shares 10,000 shares 10,000 shares 10,000 shares 10,000 shares 10,000 shares

8. Uses of Dark Pools of Liquidity How are they used? What are their advantages? What are ATSs? Figure 1.1 – ATS Impact on Open Market Equity Trading 1 Source: Aite Group Independent Research, 2007 Traditional exchanges have grown worried “Dark Pools” (ATSs) have funneled away business NASDAQ/NYSE have forged partnerships with foreign exchanges Also purchased smaller ATS exchanges

9. Uses of Dark Pools of Liquidity How are they used? What are their advantages? What are ATSs? Although studies don’t agree on the %age, they all agree “dark pools” are growing Domestically and Globally

10. Potentials for Abuse Do Dark Pools have potential for Abuse? Have they been abused? Lack of Transparency = Lack of Regulation Lack of Regulation = Abuse? Open markets work with the SEC Cooperation occurs to Investigate potential abuses/fraud SEC can fine…heavily SEC fined NYSE/Nasdaq $8.25 million…for failure to keep emails Gives SEC leverage with regards to regulating/implementing rules in open markets

11. Potentials for Abuse Do Dark Pools have potential for Abuse? Have they been abused? In closed markets (ATS’s), there is little to almost no regulation Buyers & sellers essentially, regulate themselves Can we really trust large fund managers to regulate themselves? “Why regulate when were making money?”

12. Potentials for Abuse Do Dark Pools have potential for Abuse? Have they been abused? Recent years financial modeling and computerized high volume fast paced trading have changed the marketplace In a closed exchange, this could lead to abuse Primarily, Pricing arbitrage ar·bi·trage [ahr-bi-trahzh] –noun the simultaneous purchase and sale of the same securities, commodities, or foreign exchange in different markets to profit from unequal prices.

13. Regulations regarding Dark Pools Are Dark Pools Regulated? Dark Pools lock out the “little guy”! People who don’t buy in large blocks Individual Traders Is that really fair? Regulation changes depending on country Asia Dark pools put on open exchange Europe MTF by UBS immediate post trade data available

14. Regulations regarding Dark Pools Are Dark Pools Regulated? What about the United States? SEC is enacting new regulations to tackle unfairness which arises due to ATS use in 3 ways… Amending the definition of “bid or offer” Lowering the trading volume threshold that triggers the ATS order display Changing the existing joint- industry transaction reporting rules to require post-trade disclosure of the identity of the dark pool on which each trade is executed. Mary Schapiro SEC Chair

15. Recommendations How Should Dark Pools be regulated? What do we think? Ultimately what began as a “support” system for investors trying to unload large numbers of shares, has become something entirely different Essentially, we know have a two tier marketplace A market for low volume trading that is open and regulated Another market where large firms can trade huge amounts of shares with little to no regulation or oversight Dark pools can potentially be a systematic risk… Disclosure is essential in a global marketplace

16. Recommendations How Should Dark Pools be regulated? Questions? Thank You!