An increase in anonymous trading makes waves.

SEC Chairwoman Mary Schapiro last week told a gathering of securities and futures regulators at a conference in Switzerland that the agency is determining whether greater regulation is needed for a class of investment vehicles called “dark pools.” What are dark pools? The term sounds like something out of Lord of the Rings, but in reality, they’re the province of financiers, not Frodo. Dark pools, also called dark pools of liquidity, are platforms for buying and selling stocks in which not only the buyer and seller, but also the price, are kept hidden from view until after the transaction is complete, after which the price is disclosed. Institutional investors use dark pools for block trading, which is buying or selling 10,000 shares or more in a single order.

Some are owned by investment banks. For instance, the two largest dark pools are, respectively, Credit Suisse's CrossFinder and Goldman Sachs' (GS) Sigma X. CrossFinder traded an average of 147.2 million shares daily in August, while Sigma X had daily volumes of 137 million that month, according to Rosenblatt Securities Inc., an investment firm that tracks dark pools. Other dark pools are independent ventures, although financial institutions do invest heavily in these startups. One called  Liquidnet operates like a Wall Street version of Napster; it’s a peer-to-peer network embedded behind an investors’ firewall that pings them when deals that match their shopping list enter the system.

Dark pools have proliferated over the past couple of years, along with an alphabet soup of other types of nontraditional trading venues such as ATSs (alternative trading systems) and ECNs (electronic trading networks), thanks to the 2005 passage by the Securities and Exchange Commission of Regulation NMS, which eliminated some long-standing practices that gave the exchanges an unfair advantage. With the playing field leveled, established institutions and startups alike scrambled to build better algorithms and faster systems. Dark pools alone accounted for 12 percent of all equities trading volume in the second quarter of 2009, according to the Boston-based research firm Aite Group.

The increased reliance on algorithmic programs to automatically execute trades, as well as a 2001 regulatory change that lets traders price stocks down to the cent, have brought down the number of shares per trade to less than 300, on average. As a result, there’s less demand and less available liquidity for block trades, which is the term used for moving blocks of 10,000 shares or more of a single stock. A seller posting a large block trade on one of the public exchanges, especially in today’s volatile market, would almost certainly take a hit as a result of what’s called market impact cost.

In more (ahem) concrete terms, say I own a McMansion in a subdivision full of bungalows. It’s an iffy market, and several of my neighbors are trying to sell their houses. What’s going to happen if I slap a seven-figure price tag on my abode and stick a For Sale sign in the front yard? (Hint: the answer’s in your local paper’s real-estate section.)

In the same manner, a block trader taking his or her shares to the public exchanges would have to deal with lackluster demand that would exert a downward pull on the per-share price, combined with the price decrease that would come from dumping so many shares on the market at once. In dark pool trading, on the other hand, a trader can set his or her price and conduct negotiations without rocking the boat.