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July 6, 2009

SEC Worried About Dark Pools

By Peter Chapman

The Securities and Exchange Commission has dark pools in its sights. Top SEC officials have gone on record recently criticizing the impact dark pools have on the price discovery process. While they did not promise any action, their attitude suggests a shift from their traditional hands-off approach.

At an industry conference in May, James Brigagliano, co-acting director of the SEC's Division of Trading and Markets, said dark pools could impair price discovery by drawing valuable order flow away from the public quoting markets. "To the extent that desirable order flow is diverted from the public markets, it potentially could adversely affect the execution quality of those market participants who display their orders in the public markets," he said. Brigagliano added that anything that "significantly detracts from the incentives to display liquidity in the public markets could decrease that liquidity and, in turn, harm price discovery and worsen short-term volatility."

Brigagliano was speaking in New York at a conference on market structure sponsored by the Securities Industry and Financial Markets Association. He is a 20-year SEC veteran.

His comments were echoed by a subordinate at the same conference. "Is dark liquidity undermining the price discovery process and the incentives to display?" David Shillman, an associate director in the Division of Trading and Markets, asked attendees.

If so, he suggested, the SEC might respond. One possibility could be to pass a rule that protects same-priced quotes from being ignored. Such a rule would require traders faced with two quotes at the same price to trade against the one posted first. Current SEC rules protect superior-priced quotes from being ignored, no matter when they were posted. There are no rules protecting time priority.

Shillman acknowledged that solutions to the problems presented by dark pools "could include more radical ideas." That would not include a CLOB, or single trading book, he said, but "There could be other ways."

If the SEC doesn't decide to act on its own, it could get a nudge from Congress. Last month, a top NYSE Euronext executive petitioned Congress to pressure the SEC to re-examine its regulatory regime for alternative trading systems, particularly dark pools.

"Through so-called dark pools," Thomas Callahan told Congress, "ATS operators have been allowed to create private markets for securities transactions, which the acting co-director of the SEC's Division of Trading and Markets has acknowledged 'can harm price discovery and worsen short-term volatility.'"

Callahan is an NYSE Euronext executive vice president and head of the exchange operator's futures business, NYSE Liffe U.S. He was testifying before a House Financial Services Committee hearing on regulation of the over-the-counter derivatives markets. His remarks are from his prepared testimony.

Callahan stressed that ATS operators should be subject to the same regulatory oversight as exchanges. This "disparity" in regulation, Callahan noted, "has placed exchanges at a significant competitive disadvantage."

Callahan is at least the third exchange executive to publicly question the role of dark pools and off-board trading in general in recent months. In May, Brian Hyndman, a senior vice president with Nasdaq's transaction services group, told attendees at the SIFMA conference that "retail customers are being disadvantaged because more trading is being done off-board in opaque markets."

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