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June 18, 2008

Play Ball!

Why Yankee Stadium is more fair than Reg ATS

By Dan Mathisson

On my way with my three boys to a Yankees game recently, we passed a bunch of guys in front of the parking garage waving tickets in the air and doing that scalper chant: "Who needs four? Who needs four?" I wanted my kids to enjoy an old-fashioned baseball afternoon, so this seemed like a perfect start, for what could be more traditional than some classic floor-style trading action? Guys shouting out sell indications, waving their arms, trading paper tickets-it was history come to life.

A block closer to the gate, we came across another guy holding two fingers in the air, shouting "Looking for two ... I need two." Despite a sell imbalance two blocks away, there appeared to be a buy imbalance on this block. It's certainly not surprising that buyers and sellers at the stadium don't always match up, but what is surprising and disappointing is that the U.S. equities market isn't always better. Due to flaws in Reg ATS, buyers and sellers at overlapping prices are still sometimes failing to pair off.

Fairness Issue

Reg ATS is the Securities and Exchange Commission rule that governs alternative trading systems, a.k.a. dark pools. Conceived in 1998, Reg ATS dark pools have been wildly successful, leading to today's marketplace, where it's estimated that almost a billion shares per day now trade under the regulation. The SEC's original release explaining the regulation said that ATSs have an "obligation to provide investors a fair opportunity to participate in their systems," and a series of "fair-access" rules were defined.

But the fair-access rules in Reg ATS were poorly conceived, and could be more accurately named the "no-access" rules. The current rules state that ATSs only have to open to the public in any individual stocks where they have exceeded 5 percent of the volume for four of the past six months. On top of that very high bar, there is a long list of exemptions, including inexplicably exempting any ATS that systematically prices at the midpoint. And even if an ATS were to hit the 5 percent bar in a particular stock, in the real world there's still no way to connect and get your rightful access. There's currently no Web site or database maintained by the regulators where you can go and see what names are open to the public this month. As far as I know, no ATS has ever exceeded the threshold, but then again, how would I or anyone else know if one had? If you did somehow sniff out that a given ATS was open to the public in a name this month, you'd then still have to negotiate and sign contracts, run dedicated lines, certify the FIX connectivity, set up booking and clearing, etc. By the time you were ready to trade, the fair-access period for the stock would have long expired.