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Cutting through the muck of "dark pools"

The $154 million settlement reached between regulators and Credit Suisse Group (CS) and Barclays is throwing a spotlight on a type of trading few outside of Wall Street know of or understand: "dark pools."

Despite the ominous name, dark pools do play an important role in helping institutional investors trade large blocks of stocks and bonds. Dark pools aren't open to the public, but average investors can still benefit from them if they invest in mutual funds or participate in a pension fund, advocates of these exchanges say. The pools, operated by broker-dealers, match buyers and sellers but don't publish the trade information.

Institutional investors use dark pools to reduce their trading costs and to trade securities anonymously. That's accomplished through electronic platforms that divide bulk orders into smaller trades, which can be executed more quickly and at lower costs.

Though devised mainly for use by large institutions, dark pools are now used by many different kinds of investor. In 2014, according to Reuters, about 40 percent of all U.S. stock trades, including almost all orders from retail investors, occurred "off exchange," up from around 16 percent in 2008.

In announcing the settlement, the Securities and Exchange Commission charged, among other things, that Credit Suisse and Barclays failed to properly supervise their dark pool exchanges to prevent "predatory" and "opportunistic" traders from conducting trades in violation of federal securities laws.

The investigations, conducted jointly with New York Attorney General Eric Schneiderman, found that high-speed traders could get early access to dark pool trades and gain an unfair advantage. It was a practice brought to light in author Michael Lewis's best-selling book, "Flash Boys: A Wall Street Revolt."

According to Reuters, there are about 45 dark pools in operation . In addition to Credit Suisse and Barclays, many other large Wall Street firms operate dark pools, including Citigroup (C), Goldman Sachs (GS), JPMorgan (JPM) and Morgan Stanley (MS). There are also dark pools operated by exchanges and electronic market-makers.

Dark pools first appeared in the 1980s, but began to proliferate with the passage of the so-called Regulation Alternative Trading Systems rule in 1998, which was expanded seven years later with the "Regulation National Market System." Together, the rules were aimed at making markets more efficient and competitive. And it worked. The changes caused a proliferation in electronic trading networks, significantly cutting trading costs.

Dark pools were started to solve the problem of high-frequency traders, or "flash boys" as described in Lewis's best-selling book, gaming trades on public exchanges. By using ultra-fast telecom links, microwave towers and special access to the exchanges, such traders are able to gain an edge over their competitors. They can buy or sell large amounts of stock microseconds ahead of ordinary investors.

A dark pool is just one of several different ways that a brokerage can fulfill a customer's order. In a dark pool, fees are lower, trades are anonymous and orders don't get reported until after they've been executed.

Who are the victims of a rigged stock market?

Public exchanges, provided they're adequately regulated, create a more even playing field for investors by providing wider access to pricing information. When they receive an order, the price of the stock is adjusted, and everyone with a data feed sees it. If a lot of people want to sell a stock, the price goes down; if a lot of people want to buy, it goes up.

Dark pools are the exact opposite of that. They report data only after a trade has occurred, denying investors critical information.

Critics of dark pools warn that they bear many of the same drawbacks of investments that worsened the 2008 financial crisis: lack of transparency, under-regulation and, because of the volume of trades they now handle, systematic links to the global financial system and economy.

So while they have their benefits, investors would benefit if dark pools were a bit more transparent.

"These cases mark the first major victory in the fight to combat fraud in dark pool trading and bring meaningful reforms to protect investors from predatory, high-frequency traders," Schneiderman said in a statement announcing the settlements with Barclays and Credit Suisse.

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