Proposals by the Securities and Exchange Commission could crimp the growth of dark pools that aren’t fully dark and that don’t execute blocks.
The SEC last month proposed a revision to three existing rules to address problems it sees with dark pools. The main problem is that dark pools, which account for 7.2 percent of consolidated flow, represent a significant chunk of orders and trading. With that much electronic trading happening in the dark, the SEC said, more publicly available quote and trade information is necessary.
The SEC stressed that it does not want to see the emergence of two-tiered markets. So, it is drastically paring back the ability of dark pools to attract more flow from other dark pools and venues through the use of "actionable indications of interest." It is also requiring real-time post-trade reporting that identifies the dark pool where the execution occurred.
The Commission said that it "preliminarily" believes the "majority of information about orders in NMS stocks communicated by ATSs to selected market participants … should participate in the public price discovery process." The SEC also said that post-trade data about which dark pools are executing orders should be available immediately to the public.
First, the SEC plans to change a rule in the 11-year-old Regulation ATS that requires dark pools to publish quotes that are selectively displayed to market participants. Instead of a dark pool triggering this obligation when it trades 5 percent of a stock on a monthly basis, a dark pool will be limited to less than 0.25 percent before the obligation kicks in.
"The proposed display threshold of 0.25 percent is designed to keep barriers to entry for new ATSs low so as to promote competition, while reducing the amount of important price information that is selectively displayed outside the public quote stream," the SEC said.
Second, the regulator plans to amend Rule 602, or the Quote Rule (formerly Rule 11Ac1-1), of Regulation NMS, to include "actionable IOIs." The SEC said these IOIs are quotes even if some of the information about symbol, side, price and size are implicit rather than explicit.
Taken together, these two rule changes would likely end the practice of dark pools communicating with one another. About a dozen of the 30 registered dark pools currently send IOIs, according to the SEC. The SEC equates this practice with flash orders, insofar as flash orders also give select market participants information about orders that the public cannot access.
Industry executives at the Security Traders Association’s annual conference in October said broker-dealers might find ways to work around any new SEC proposals regarding what constitutes a quote. Some suggested that actionable IOIs improve the ability of institutions to find contra-side liquidity, lowering their total costs. In their view, pushing orders further into the dark by curtailing the use of IOIs could be counterproductive.
The SEC’s third proposal requires immediate post-trade reporting for dark executions that identifies the pool in which the trades occurred. An exception would be allowed for trades valued at $200,000 or more. Those prints could be identified as over-the-counter trades, as they now are. This proposal is likely to have the biggest impact on trading in a range of dark pools, if enacted as planned.
Many dark pools are in favor of more dark pool post-trade transparency. However, many also argue that real-time reporting of the venue where the print occurred would be harmful, particularly since high-frequency traders are the likeliest candidates to benefit from the information. In general, they note, that would scare buyside traders away from dark pools. Other traders, seeing that a stock traded in a particular pool, might be able to figure out whether an institution was behind the trade and take a position to trade ahead of what could be a much bigger order.
The SEC believes post-trade reporting for dark pools should be comparable to requirements for exchange reporting. In the regulator’s view, ATSs such as dark pools are close cousins of exchanges and should operate on a relatively even playing field with self-regulatory organizations, providing the same post-trade reporting transparency.
SEC’s Proposed Rules
IOIs: Actionable IOIs that include symbol, side, price and size will be deemed quotes.
Display threshold: A dark pool that executes more than 0.25% of a stock’s monthly ADV must publicly display and provide access to quotes.
Post-trade reporting: ATSs will have to identify their venue in real time when reporting trades to the tape.
Note: IOIs for blocks with a market value of $200,000 and block prints will not be subject to these new rule changes.
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