A Securities and Exchange Commission proposal intended to limit brokers’ off-board trading is unlikely to drive more orders to the public markets, industry officials contend.
Instead, the rules, which target brokers’ use of "actionable" indications of interest, will most likely force brokers to "blind ping" each others’ dark pools, execs say.
As part of the SEC’s "Regulation of Non-Public Trading Interest" proposal, issued in mid-November, the regulator is suggesting two new rules that could sharply curtail brokers’ use of so-called actionable indications of interest. That, it hopes, would force the brokers to convert the IOIs into orders and send them to the exchanges.
The SEC is primarily targeting operators of dark pool alternative trading systems who transmit trading messages electronically to other dark pools and hidden sources of liquidity. But any rule changes would also affect exchanges and over-the-counter market makers. The regulator says it has identified 11 of 29 dark pool ATSs that use actionable IOIs.
While many brokers agree on the need for rules governing actionable IOIs, they don’t think the changes will lead to more quoting in the public markets. That’s because the messages are used to service clients seeking anonymity and to avoid costly exchange fees.
"Anyone who believes these new rules will result in new information being made public is kidding himself," said Kevin Foley, chief executive of Aqua, an operator of a dark pool ATS. "Behavior will simply change." (Aqua transmits "orders," but not actionable IOIs, Foley explained, and is therefore not subject to the proposed rule changes.)
The SEC is proposing changes to Regulation NMS and Regulation ATS. It wants to amend Rule 602 of Reg NMS, best known as the Quote Rule, to add actionable IOIs to the definition of bids and offers. If the regulator succeeds in reclassifying actionable IOIs as quotes, then certain brokers sending the IOIs to a limited group of recipients would be required to display them to the entire marketplace.
The regulator is not just targeting brokers generally. It is also looking to change the practices of ATSs, namely dark pools. The SEC wants to amend Rule 301 of Reg ATS to force those ATSs who distribute order information to more than one party to make that information public. Under current rules, ATSs trading more than 5 percent of a security’s volume must report that information to the Consolidated Quotation System. Under the proposed rules, the threshold is lowered to 0.25 percent, thereby roping in much more ATS trading.
Importantly, the proposed changes to Reg NMS and Reg ATS exclude actionable IOIs transmitted on behalf of orders with values equal to $200,000 or more.
Liquidnet Holdings is one such operator of dark pool ATSs that would be affected by any new rules, albeit to a limited extent. While most of its orders exceed $200,000 in value, its H20 system transmits actionable IOIs to certain parties on behalf of smaller orders as well. Liquidnet executive Jay Biancamano said his firm has already made changes to its system to reflect any changes to the rules.
Biancamano and other trading executives believe any new rules will not cause brokers to suddenly start displaying quotes in the public markets. Rather, they will step up their use of immediate-or-cancel orders to "ping" electronic sources of liquidity. "Pinging is going to become the norm," Biancamano said. "We have upgraded our system to have a pinging model." Pinging involves blindly sending IOC orders to dark pools and other hidden sources of liquidity in the hope of finding a match or drawing a response.
Other executives note that the SEC did not provide a definition of an IOI in its rule proposal; that could give them some wiggle room. Currently, most actionable IOIs include symbol, side, size and price. If two or more of those variables are left off, traders ask, would the IOIs be exempt from any new rules?
"If the SEC calls an IOI a quote, they’re going to draw the line somewhere," Jamil Nazarali, global head of electronic trading at Knight Capital Group, said at an industry conference in October. "If you have price, size and side, that’s a quote. But if you take off whatever–price or side–it’s not a quote. I can’t imagine them saying if you just indicate a symbol, that’s going to be a quote."
Knight uses a variety of different IOI types to source liquidity in connection with its market-making business.
Len Amoruso, Knight’s general counsel, told Traders Magazine recently that Knight and other firms might also replace actionable IOIs with whatever is not considered an actionable IOI. "We expect market participants may migrate to whatever type of IOI they are permitted to use," he said.
Amoruso added that market participants today use both quotes placed on exchanges and IOIs to source liquidity from participants in the marketplace. He added that IOIs could be more attractive for a number of reasons, including speed and pricing.
"When firms interact with each other, there’s no exchange fee," he said. "That brings additional liquidity into a market that would not have necessarily been there. So it can be a much less expensive way to trade."
Nazarali told Traders Magazine that forcing liquidity-providing firms to publish their trading interest as quotes may not result in firms "taking what was an IOI and putting it in a quote, since they had a legitimate reason for using an IOI in the first place. Firms may not want to quote out loud for all market participants in all circumstances."
The SEC is asking for comments to the proposal by Feb. 22, 2010.
