Europe's regulators are closing in on reform of "dark pools" stock trading, a move aimed at increasing transparency but which long-term investors fear will increase their trading costs.

Banks such as Deutsche Bank, Morgan Stanley and UBS, have always allowed clients to trade privately and away from public stock exchanges, by matching client orders with orders from their own proprietary trading desks.

These so-called dark pools are popular among banks and their big buy-to-hold clients, because they can avoid both stock exchange fees and the potential cost of 'market impact' - whereby a big purchase or sale in a transparent market alerts traders to an opportunity to make money by forcing the price up or down.

Users of these more opaque services say they are a necessary part of a smooth functioning market for investors whose primary aim is to make money from capital gains and dividends rather than from the act of trading itself which motivates many players on the regulated exchanges.

"The fear is regulators will tie down the rules on dark pools so they (stock markets generally) all end up looking the same," said Tony Whalley, the head of dealing at Scottish Widows Investment Partnership.

According to Andrew Bowley, head of electronic trading product management at Nomura, "more restrictive crossing of orders will make it harder for institutions to trade larger orders through market impact costs".

ONE SIXTH OF EUROPEAN SHARE ACTIVITY

Dark pools trading used to be mainly conducted by telephone, but it has moved to electronic platforms in recent years to make the matching of trades more efficient and further cut its costs.

These efficiencies and cost advantages have allowed the industry to flourish, and dark pools now account for an estimated one sixth of European share activity, or about 100 billion euros ($130 billion) of trading each month.

Banks charge anything from one to 20 basis points for dark pool trades, depending on the order and the client, meaning this business nets the handful of banks and brokers that offer these services up to 100 million euros each month.

This represents a potentially useful source of revenue for the banks at a time when their equities teams are struggling in a low volume, highly competitive market - one reason why the investment banks themselves are resistant to reform.

Despite these arguments, the European parliament want to subject dark pools to the same levels of transparency as public stock exchanges, part of its push to make markets more transparent and, therefore, easier to monitor.

The European Commission would force bank dark pools to become regulated as electronic stock markets, known as multi-lateral trading facilities (MTFs), which means they must offer much higher levels of price transparency than they do currently.

The regulatory reforms on dark pools are only at the proposal stage, and the banks are hopeful they can still convince lawmakers to soften their line and allow dark pools to maintain some level of opacity.

To this end, the banks have recruited the support of their pension fund customers who have this year been meeting with European policymakers to help them understand how their draconian reform plans will impact their trading activities.

But, mindful of the political will to clamp down on investment banks after the financial crisis, some are now thinking seriously about what they will do if the worst happens and the European Commission goes through with its dark pool reform agenda.

Some banks have already taken the plunge and launched more transparent MTF-compliant dark pools, effectively hedging their bets over whether the Commission will force their systems to take this step.

Nomura was the first bank to go when it launched in January 2010 its NX dark pool, having secured clearance from the British regulator the Financial Services Authority (FSA).

UBS, Goldman Sachs and, most recently, Credit Agricole have since followed suit, with the Cheuvreux, the brokerage unit of the French bank, unveiling its dark pool, called Blink MTF, just last week.

"We felt it important to register Blink as an MTF to provide our clients and the market with maximum transparency," said Ian Peacock, global head of execution services at CA Cheuvreux.

The dark pool reforms, which are part of a broad overhaul of the Commission's 2007 Markets in Financial Instruments Directive (Mifid), which paved the way for the emergence of dark pools in the first place, won't take effect until at least 2015.

This leaves those banks that have not secured MTF status at least two years to process their applications but, with the regulators showing no sign of watering down their plans, the other banks are thinking about re-filing their dark pools as MTFs.

"We would like to continue offering our dark pool under the current legal requirements and we are currently focused on educating the regulators on the importance of lighter regulation," said the head of electronic trading at one large U.S. investment bank.

"But, if we are forced to adopt a tougher regime, we will and I expect all the other major banks to do likewise," he said.

The FSA, which itself is set to be overhauled itself next year and broken up into separate regulatory bodies, could then be facing a flood of applications, as European regulators forge ahead with the dark pool reforms over the coming year.

And MTF application is no small matter, tying up management time, as well as resources, for the best part of a year.

The re-regulation of broker dark pools may hurt clients, the traders say, but they also doubt whether the regulatory reforms will even have the desired effect.

"I'd question whether another 20 regulated markets is really going to add to transparency," said Mark Hemsley, the chief executive of Bats Chi-X Europe, the European MTF operator. ($1 = 0.7559 euros)