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.
Since the rule has no teeth, it is left completely up to ATS owners to decide who gets to play in their sandbox. And, not surprisingly, not all the kids are playing nicely, with some dark pools choosing to deny access to various players. The result is a world where a 35-cent bid may not be able to cross with a 33-cent offer. It is not illogical for some ATSs to shut out broker-dealers: Smaller ATSs survive by gathering a few million shares per day from loyal clients, and then sell access to that liquidity (marketed as better or cleaner than exchange liquidity) for an above-market rate. Allowing broker-dealers to play gets more volume in the pool, but risks ruining the game, as brokers have been driven by clients to aggregate destinations, leaving the ATS without a claim of exclusive liquidity.
Stepping Up
So unless the fair-access rules change, the fragmentation problem caused by Reg ATS is not likely to heal itself. The good news is that dark pools that deny open access currently only account for about 4 percent of the total U.S. equity volume, so clients can still sweep almost the entire market with one order. But with ATS volume growing rapidly, the Balkanization of Wall Street will become a real problem if the regulators don’t step up to the plate. It is easy to envision a future with several dozen little exclusive ATS pools, each of which gathers a few thousand orders per day.
Based on the cost and time needed to establish connections with ATSs, a functional fair-access rule can no longer be stock-specific or apply for such a short period of time; it’s completely impractical to connect to a destination for such limited use. ATSs should have the same fair-access rule as exchanges or ECNs: Let in all traders at a uniform price policy based on objective standards. No discrimination allowed. And keep alive the dream of one virtual national market, with buyers and sellers able to pair off the way nature intended.
At Yankee Stadium, buyers and sellers may not always be on the same block, but at least the hundreds of impromptu auctions taking place are open to all. While watching the heart-warming stadium display of free markets in action, my sons thought it was funny when the scalpers suddenly bolted as a cop rounded the corner. Here’s hoping we get a change of rules in both areas—the scalpers are providing a fair and open service; it is the exclusive ATSs that should be on the run.
Dan Mathisson, a Managing Director and the Head of Advanced Execution Services (AES) at Credit Suisse, is a contributing writer to Traders Magazine.
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