Large broker-dealers that operate dark pools spoke out against the idea of imposing onerous new rules on their activities at last week’s TradeTech USA conference.
The backlash came in the wake of a recommendation by an advisory committee convened by the Commodity Futures Trading Commission and the Securities and Exchange Commission that the SEC consider adopting a so-called "trade-at" rule. Such a rule could make it significantly more expensive for brokers to internalize, or trade within their dark pools, their customers’ orders.
"The big game changer is the threat of a trade-at rule," Todd Lopez, a managing director and co-head of Americas sales at Goldman Sachs Electronic Trading, operator of the SigmaX dark pool, said at the conference. "Whether you believe it will happen or not, it will be debated. The advisory committee ensured that would be the case."
A trade-at rule would require broker-dealers to think twice before they traded against one of their customer’s incoming orders. It would bar them from trading the order at a price that merely matched the national best bid or offer. The broker would have to either route the order away or fill it at a price better than the existing NBBO. Any rule could benefit the public exchanges, if brokers did not internalize and price improve the orders.
Last year’s Concept Release, published by the SEC, suggested that "price improvement" could be as much as one cent, a considerable amount in an era where spreads on many stocks are a penny. Higher price improvement costs could lead brokers to route out more of their flow.
At TradeTech, brokers said being forced to route out orders to the public markets would result in bad executions. "One of the advantages of matching up two client orders at the bid or offer is that I don’t have to send it to the public market and run the risk it will be gamed," said Owain Self, UBS’s head of algorithmic trading for the Americas and the EMEA region.
The fear of gaming by high-frequency traders has become a major concern for money managers and their brokers these days, as the amount of fast-paced speculative trading has surged.
"If all of the orders wind up in the lit markets, who’s going to be first in the queue every single time?" Self asked. "It will be the HFT because he’s faster than everybody else. So I will always be behind him. He knows what my clients are doing. Internalization is a way to limit that."
Dmitri Galinov, head of liquidity strategy for Credit Suisse’s Advanced Execution Services group, operator of the Crossfinder dark pool, also believes trade-at is a bad idea. He noted that it costs more to route an order to a stock exchange or ECN than it does a dark pool. "Why should I be forced to pay 30 mils at an exchange when I can take a dark pool and pay 5 mils?" he asked. "It doesn’t make sense."
The SEC first broached the idea of a trade-at rule last year out of concerns that too much trading was occurring off-board, thereby impairing the price-discovery process. The thinking is that internalization discourages traders from posting orders on public books as they may not get a chance to interact with a contra-side order.
The SEC is wrestling with the idea of reining in some of that trading, which recently accounted for one-third of all share volume. Most big brokers internalize flow. It allows them to reduce their trading costs and, they say, provide better executions for their clients.
Adding to brokers’ anxiety is tough talk overseas about imposing restrictions on dark pools. "In Europe and Canada, some proposals on the table are extremely restrictive with either price improvement or transparency requirements," Laurie Berke, a Tabb Group analyst, noted at the confab.
Not all brokers are opposed to a trade-at rule. "I am a fan of the rule," Jatin Suryawanshi, head of global quant strategy at Jefferies & Co. "It provides priority to the person who was actually willing to bid out loud for the stock."
Suryawanshi likes the fact that a trade-at rule would prevent the limit-order trader from being "front-run by a teeny-weeny amount of price improvement." He cited research that showed about 70 percent of all internalized orders are filled at prices no more than 5 percent away from the bid or offer. Only about 22 percent or 25 percent are done at the midpoint, or are significantly price improved. He is in favor of "making it mandatory for a significant amount of price improvement to happen in order to gain access to those orders." (Jefferies does not operate a dark pool.)
Despite their opposition to a trade-at rule, most of the dark pool operators are skeptical one will be written into the rulebook anytime soon. For one thing, the SEC has too much on its plate to tackle such a controversial proposal.
"I don’t see it happening this year," Credit Suisse’s Galinov said. "It’s probably unlikely next year as well."
