Trading industry executives offered a clear message to the Securities and Exchange Commission on changing current rules surrounding the "IOIs" used by dark pools: Be careful.
Panelists during a session at the Security Traders Association’s annual conference last week argued that automated indications of interest can benefit clients by providing better prices and greater access to liquidity. Their fear is that new rules may have unintended consequences that negatively impact clients.
Today is a big day for dark pools, since the SEC is expected to propose rules that alter the way IOIs are treated, along with other regulations affecting dark pools. The expectation is that IOIs sent between dark pools and other venues will be deemed quotes, and will therefore have to be made publicly available once a dark pool reaches a certain size.
Jamil Nazarali, a managing director in the electronic trading group at Knight Equity Markets, said at the STA conference in Scottsdale, Arizona, that the prospect of new rules around automated IOIs used by dark pools could be a slippery slope that raises basic questions about off-board trading. The ramifications of this, he said, could be significant.
"Is the whole practice of internalization bad?" he asked. "Should the wholesale market makers disappear? Should all the broker-dealers have to send their orders to an exchange, and [should] we have to move to a central limit order book? Where on that spectrum do you draw the line?" For Nazarali and other trading executives, upcoming regulatory changes in this niche area of the trading industry could open up broader discussions about the business, jeopardizing practices that have evolved around dark pools.
The SEC is expected to usher in several prospective changes today that affect how dark pools operate. These planned changes are designed, in part, to avoid what the SEC calls "two-tiered markets" in which information about orders in dark pools is sent only to select market participants. They are also designed to limit the amount of trading that takes place in dark pools in the aggregate as well as in individual pools.
One way regulators may do this is by lowering the threshold at which quotes must be publicly displayed and by redefining actionable, or immediately executable, IOIs as quotes. The current 5 percent threshold for quotation display may be reduced to around 1 percent. If a dark pool executes that lower percentage of a security’s average daily volume in four of the previous six months, it must display quotes shown to more than one party at a time.
IOIs would fall into the camp of messages requiring public display. And since dark pools exist to avoid information leakage associated with publicly displaying a trader’s intentions, this restriction would likely function as a lid on dark pool growth. But whether this would actually rein in the portion of volume executed in dark pools is less clear. Many brokers expect that rule changes involving dark pools may shift flow around in non-displayed venues, but may not succeed in pushing it onto exchanges–a result that some exchanges are clearly hoping will occur.
Nazarali expects that if automated IOIs are redefined as quotes, brokers may shift to using indications that are clearly not quotes. A broker, he said, could send out a message containing just the symbol, or symbol and size but no side, to seek out liquidity. The goal of executing quietly in the dark, he said, wouldn’t disappear.
Whit Conary, president of LeveL ATS, a dark pool owned by a consortium of broker-dealers, told the STA audience that dark pools should provide more transparency about how they operate and whether they send out IOIs. He doesn’t think IOIs routed between dark pools are necessarily harmful, but that traders should know if indications are being used to find the other side for their orders. His dark pool doesn’t use them.
Many firms on the buyside and sellside consider outbound IOIs information leakage. These IOIs, typically routed between dark pools and other venues, are sent not to humans but to the matching engines of other pools or to other venues. They’re used to rustle up liquidity and produce more executions.
Brokers in general do not object to cries for more transparency around dark pools. They recognize the need for consistent volume reporting by dark pools, since dark pools currently count matched and handled shares in a variety of ways. This lack of standardization makes it virtually impossible for firms to compare the level of executions in many pools. Regulators have telegraphed the likelihood of new rules around how trades are counted and reported for almost half a year now.
Brett Redfearn, global head of liquidity in the Electronic Client Solutions unit of JP Morgan Securities, said he suspects that regulators will require dark pool IOIs to contain less information than they currently do in the dark pool world, to avoid being considered quotes. He stressed, however, that many kinds of IOIs exist, based on the size of the order, the way the information is disseminated, and whether the message is actionable or not. In his view, this complicates the landscape.
Ruth Colagiuri, head of Americas electronic products at Bank of America Merrill Lynch, noted that one of her firm’s worries is that changes to the regulatory treatment of IOIs could wind up hurting broker-dealers’ high-touch trading operations. The "fear" at BofA Merrill, she said, is that "something will come in that compromises the way our high-touch desk has done business forever."
So far, the SEC has not said it would alter the way traditional IOIs are used by broker-dealers to execute blocks. Jamie Selway, managing director at institutional broker White Cap Trading, pointed out that an IOI in the traditional institutional world remains "an invitation for a phone call," not an invitation for an electronic message that has a 60 percent probability of execution in several microseconds. The latter, he said, resembles an order more than an indication and therefore may well warrant different treatment.
Still, Redfearn of JPMorgan Securities highlighted what he called a "strange paradox" in how automated IOIs are used by dark pools and broker-dealers. Instead of leaking information, which is a common concern with indications of interest, he said, inbound IOIs can help brokers avoid information leakage and improve clients’ execution fill rates.
For institutional clients that agree to allow routing to electronic liquidity providers that trade proprietarily, he said, JPMorgan Securities would be okay with receiving IOIs from those liquidity providers. Based on that information, the firm would decide when to route client orders to those venues. Redfearn said his firm does not send out IOIs because of the information leakage that would result from doing so.
But by taking in IOIs, Redfearn said, brokers can avoid excessive "blind pings" to external venues and ensure a higher fill rate. "As [regulators] cut back on information in an IOI, it would cut back on the fill rates we get," he predicted. And if the fill rates shrink too much, his firm may not turn to those liquidity providers because lower fill rates could mean more information leakage.
Nazarali agreed that if the SEC characterizes IOIs as quotes, firms would see "more leakage of information" from the "blind pinging" of liquidity pools to seek out contra-side flow. He said there is less information leakage when a broker responds to an IOI it receives from other entities.
In fully non-displayed liquidity pools, Redfearn added, his firm sees less market impact than it does with exchange executions. He noted that the concerns of some exchange executives that exchanges and alternative trading systems may be getting different regulatory treatment are partly valid, but that the push-pull also "gets into competitive issues and pricing issues."
The JPMorgan executive pointed out that in addition to execution quality, brokers use electronic liquidity providers to find the other side of trades to avoid the high cost associated with exchange executions. These firms, he said, typically execute for free, whereas taking liquidity from an exchange can cost up to 30 cents per 100 shares.
Prospective regulatory restrictions around dark pools, however, will not eliminate the need for dark pools. White Cap’s Selway noted that dark pools will always exist in one form or another because they increase execution efficiencies for sellside firms. In addition to lowering the impact costs on clients’ trades, he said, these executions avoid the fees charged by exchanges.
There are good reasons for exchanges to consolidate, Selway said, but "as long as there are ‘n’ broker-dealers looking to internalize volume or match institutional business or pair off algorithmic flow, there are going to be ‘n’ things called dark pools." These are simply opportunities for brokers to get more executions done quietly.
At the same time, Selway pointed out that Reg ATS was designed as "exchange lite" regulation–but without the expectation that these venues would rival their bigger brethren, which some now do. He said the "notion of a public Form ATS" that provides market participants with information about how orders are treated in a particular dark pool might be useful. (Form ATS is the form dark pools file with the SEC when they register and when they make material changes to how their systems operate.) "Writing down some things that look like rule filings wouldn’t be a bad idea," Selway said. In addition, he suggested, "slightly more vigorous enforcement of some Reg ATS thresholds…wouldn’t be a bad thing."
BofA Merrill’s Colagiuri said she understands concerns about regulatory disparities between exchanges and ATSs and that perhaps oversight of these venues could "come in a little closer." But she hopes ATSs do not become subject to more regulations. Many broker-dealers, she said, registered their internalization engines as ATSs to provide clients with more reassurance about how flows were treated within those pools and to be more transparent. But the more regulations there are, she said, the "less incentive there is for [brokers] to register their internalization engines as ATSs in the first place."
The panelists also discussed post-trade reporting, which the SEC is expected to address today. The SEC has indicated in recent months that some form of post-trade transparency would give market participants a better understanding of how much volume is taking place in particular securities in specific dark pools. The Commission has also said it would like to see some normalization in the way dark pool volume is counted by ATSs.
But even as the SEC moves toward more post-trade reporting of where dark pool volumes are occurring, the agency has stressed that block trades should not be subject to the same type of post-trade reporting. "The disclosure of the identity of ATSs that execute large size trades may provide too much information about the parties to a transaction," James Brigagliano, co-acting director of the SEC’s Division of Trading and Markets, said in a speech on Oct. 8 at a Trader Forum workshop in Boston. "Therefore, it may not be appropriate to require the identification of ATSs on trade reports in the consolidated trade stream for large size trades."
The STA panelists were generally in favor of more detailed dark pool reporting. The sticking point is just how real time that reporting should be. LeveL’s Conary said consistency in the reporting of dark pool volume is important. He agreed with others brokerage executives that while real-time reporting for liquid large-cap stocks would probably be fine, real-time reporting for small caps would be counterproductive. He noted that with less-liquid small caps, too much information would be conveyed, exposing those executing orders to computer models designed to identify market-moving orders that are being worked.
Redfearn of JPMorgan Securities agreed, noting that end-of-day reporting would be fine. But real-time reporting, in his view, is another matter. "I actually think prop trading shops [would be] utilizing that information more than anyone else," he said of immediate prints to the tape that identify the dark pool.
