Commentary: Shedding Light on the Dark Liquidity Debate
Traders Magazine Online News, February 16, 2010
The first bugle sounded in the battle over dark pools challenged flash orders, which provided customers a first look at certain orders before they were made available through the public quotation stream to the great unwashed mass of public investors. The current debate involves a similar issue--whether the institutional customers of dark pools should be able to show their orders on a selective basis to certain other persons without also making them available to a larger audience. The battle results from a fundamental flaw in the design of the Securities Exchange Act of 1934, which is the source of a growing conflict in market regulation.
As discussed in prior articles, the Exchange Act creates certain institutions and then imposes obligations on those institutions. Most relevant here, the Exchange Act creates something called a national securities exchange. The business of a national securities exchange is to provide a marketplace for people to trade securities. The Exchange Act also required a national securities exchange to be a self-regulatory organization, which means that it must make rules for its members, as well as adjudicate and enforce those rules.
A broker-dealer, another institution created by the Exchange Act, is required to be a member of a self-regulatory organization. In most cases, this means that a broker-dealer is a member of a national securities exchange. Broker-dealers that transact business off exchange in the over-the-counter markets are required to be a member of the Financial Industry Regulatory Authority, which is also a self-regulatory organization. Only broker-dealers can engage in securities transactions on national securities exchanges.
The Exchange Act reflected the technology of its time. In 1934, stock exchanges consisted of physical trading floors. There is a natural limit on the number of human beings that can inhabit any physical location. So, limiting access to stock exchange floors to broker-dealers was, if nothing else, required to maintain crowd control.
But, it is also useful to realize that self-regulation imposes substantial costs on the business of running an exchange that stock exchanges would not voluntarily incur in the absence of regulation. The New York Stock Exchange did not maintain rule-making, adjudication and enforcement operations until legally required by the Exchange Act.
As technology has changed, the institutional framework that established by the Exchange Act has come under increasing strain. Electronic stock exchanges provide a virtual marketplace for people to transact business. There is no meaningful natural limit on the number of people that can transact business effectively in an electronic virtual marketplace.
This tension became evident in 1988, when RMJ Securities Inc applied to the SEC for permission to operate a system that would execute trades by matching electronically bids and offers from their clients. RMJ hoped to attract business from broker-dealers, but also from institutional investors that were not broker-dealers. RMJ's application therefore presented the SEC with a Hobson's choice. Was RMJ an exchange or a broker-dealer?
RMJ's system brought together buyers and sellers of securities to execute securities transactions, which is the fundamental business of an exchange. In fact, the only way that RMJ's business differed from that of an exchange is that the marketplace RMJ proposed to operate was virtual, rather than a physical location. However, if RMJ was classified as an exchange, only broker-dealers could transact business there. In addition, RJM would have been required to act as self-regulatory organization, which involves the substantial costs of making and enforcing rules for its members. RMJ proposed to have customers, established by contractual arrangements, rather than members.
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