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April 3, 2008

SEC Warns Brokers on Dark Duties

By Nina Mehta

The Securities and Exchange Commission warned brokers they must ensure they're meeting their best-execution obligations by accessing both displayed and non-displayed liquidity for clients. This reminder comes in light of buyside concern over the fragmentation of non-displayed liquidity. Erik Sirri, director of the SEC's Division of Trading and Markets, said in February, "We look to brokers in general to solve the problem of fragmentation...on behalf of customers."

Sirri informed brokers that "blindly following routing strategies that may have worked in the past but no longer fit the current market structure is not an appropriate best-execution approach."

Instead, he said, "brokers must undertake a regular and rigorous review of the execution quality that can be obtained at different trading venues, including the possibility that a venue may have liquidity available at an undisplayed price or additional undisplayed size beyond the displayed size of a quote." Sirri made these comments at a symposium on dark pools sponsored by the Securities Industry and Financial Markets Association.

Sirri stressed that the buyside's difficulty in accessing multiple dark pools can be mitigated by technology that aggregates liquidity across the dark venues. He added that industry participants can also exert pressure on broker-sponsored dark pools, particularly those that are less successful, "either to consolidate with other pools or to cooperate with dark pool aggregators."

The Financial Industry Regulatory Authority (FINRA) seconded the SEC's best-execution focus at the same symposium. Andrew Kagan, vice president for business services at FINRA, noted that, when it comes to dark liquidity, living in a "world where there are so many execution venues definitely complicates the analysis of whether best execution is achieved." But technology, he said, offers a solution. The ability to "ping or probe and place your orders in [various] market locations provides intelligence" that should be taken into consideration when making routing decisions, he told brokers.

Asked whether there was a "bright-line test" for brokers, Kagan replied: "I'm not here to grant absolution."

The SEC's Sirri also countered rampant industry speculation that the presence of dark liquidity has hurt transparency in the market. Market participants have repeatedly wondered whether the SEC would clamp down on dark pools as their cumulative market share increased and as the number of pools grew.

Sirri said, as he has in the past, that dark pools are used by institutions to avoid information leakage and lower market-impact costs. He said they do not pose a threat to the viability of "quoting venues" and are not a particular regulatory concern for the SEC. "We don't at present have a huge concern about dark pools," Sirri said.

The SEC exec added that despite the abundance of dark pools, the market share of dark venues isn't on the rise. In December, he said, crossing systems and broker-dealer internalizers represented about 20 percent of the total U.S. equity trading volume, roughly on par with what it was in December 2004. Thus far, Sirri said, market share has shifted among dark pools rather than from quoting venues such as exchanges and ECNs to dark pools.

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