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The Liquidity Problem

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June 18, 2008

It's Gray Out There

By Nina Mehta

The Securities and Exchange Commission has allowed dark pools to flourish and compete for liquidity with the displayed markets. But now, while a swath of the non-displayed ATS trading community is focused on the costs and benefits of sending out automated indications of interest to scout for liquidity, the SEC is emphasizing the definition of a quote. An IOI, according to the commission, is just an alternative spelling of "quote," and with a quote come potential obligations.

At a Securities Industry and Financial Markets Association symposium on dark pools in February, Erik Sirri, director of the SEC's Division of Trading and Markets, said Regulation ATS, which laid down the law for dark pools, "does not permit ATSs to circumvent the display requirement by disseminating information on the availability of liquidity that effectively functions as a quote." Trading interest "displayed" to either a human being or an electronic system, such as through an automated IOI, is a quote, he said.

Robert Colby, deputy director of Sirri's division, put it more bluntly at the same conference. "You can call things un-firm, but that doesn't make [them] un-firm," he said of automated IOIs. Colby added that an IOI with "a price and a side at a minimum that's firm" is a quote.

Under Reg ATS, a dark pool or crossing system must meet the fair-access requirements that public markets are subject to for any stock in which the ATS is responsible for 5 percent or more of the average daily volume in four of the previous six months. On reaching that threshold, the pool must provide broad investor access to its services. And if that ATS publishes quotes to more than one person or entity at a time, the quotes must be displayed publicly.

However, there remains great uncertainty in the industry about what this means in practical terms. ATSs don't have to publicly report their monthly volume, so knowing when an ATS crosses the threshold is impossible. To many, it's not clear how an ATS would provide access to its liquidity to a broad array of market participants. If an ATS must display a quote, it's unclear whether the ATS could display just a token amount. And for broker-dealers with dark pool look-alikes that sit within their market-making divisions, there's additional uncertainty about whether these rules touch them.

SIDEBAR #2: Watching IOIs

Several crossing networks and dark pools are thinking about how to adapt to an increasingly automated and algorithmic trading environment through the use of indications or similar messages. These include Pulse Trading, an agency broker whose BlockCross platform is geared to institutions, and Level ATS, a dark pool owned by a consortium of broker-dealers.

Pulse's BlockCross includes several execution services. Paul Filipski, a software engineer who works on connectivity and integration for BlockCross, says the firm is now trying to figure out how buyside traders can let sellside firms pinging the system's auto-ex platform with 5,000-share-minimum IOC orders know they might be able to interact with large-size orders in what the firm calls its "confirmation mode." That mode has giant minimums.