The Securities and Exchange Commission is likely to take a black-and-white view of its planned interpretation of "actionable indications of interest" and could use enforcement actions to underscore new rules, according to a former top official in the SEC’s Division of Trading and Markets.
Robert Colby, a former deputy director of the SEC’s Division of Trading and Markets who is now counsel at law firm Davis Polk & Wardwell, said the agency has long thought actionable IOIs should be treated as quotes. "If the Commission adopts [the rules for dark pools it proposed last month], they’re not going to feel constrained any longer," he said. Colby, who left the SEC in February after 27 years, helped write all of the major equity market rules of the last two decades.
The SEC last month proposed three rule changes that would affect the way many dark pools, or non-displayed alternative trading systems, operate. Two of the planned rule changes involve actionable IOIs. Actionable IOIs are messages that indicate the presence of executable liquidity in a particular trading venue.
One rule proposed treating actionable IOIs from various entities that have quoting obligations as quotations that must be publicly displayed. The other proposed rule would require dark pools to display their actionable IOIs once they reach a certain monthly volume threshold. That threshold would be lower than the current one.
The SEC, Colby told a crowd of industry participants, may come to some of their firms to find out if IOIs they’re sending are "indeed actionable and [would] produce a quote." And the SEC wouldn’t likely tolerate pushback. Market participants may "actually see some enforcement actions if people push the limits," he predicted. Colby spoke yesterday at a breakfast consortium about current regulatory issues sponsored by Capital Markets World, a conference organizer.
The SEC’s proposed change to the Quote Rule in Regulation NMS would require the display of actionable IOIs for orders with a market value of less than $200,000. Currently, actionable IOIs fall under an exception to the Quote Rule. The new requirement would apply to three types of market participants: exchanges, over-the-counter market makers, and ATSs that exceed a certain monthly volume threshold and that quote to more than one person at a time. About a dozen brokers operating dark pools send out actionable IOIs based on orders in those pools. OTC market makers that send out actionable IOIs could also feel their business models crimped by these rules.
Colby noted that the SEC "could have re-looked at the categories" for those required to quote, but did not do that. While exchanges, OTC market makers and ATSs that meet certain requirements must quote, this group, Colby said, does not include broker-dealers that are not market makers, block positioners and other entities.
Colby’s comments echoed a "client memorandum" his law firm published three weeks ago. That note, published on Nov. 17, was written by former SEC Commissioner Annette Nazareth, Lanny Schwartz, Gerard Citera and Colby. The memo highlighted what the SEC had not included in its dark pool rule proposal in November.
Among other things, the memo noted that while ATSs, through an exception to the display requirements, would not have to display quotes for $200,000 or more that are sent to those with potentially similar-size contra-side orders, the SEC’s proposed rule does not mention non-ATSs. "Given the stated purpose of this exception to help find liquidity for large orders without having a market impact, it is curious that the SEC neither proposed nor sought comment on whether a similar exception from the quote rule should apply to exchanges and OTC market makers," the memo said.
The memo also noted that the SEC avoided stating that ATSs and other market centers would have to "treat actionable IOIs as quotes pending adoption of the rule." But once adopted, the memo said, "we anticipate that the SEC will expect firms to comply rigorously with this interpretative position and will examine practices and potentially bring enforcement actions where practices veer from the spirit of the interpretation."
In his talk, Colby noted that the SEC also did not propose altering the fair access threshold in Regulation ATS, which lays out the rules for all ATSs. The proposed rule requires that dark pools provide access to their quotes once they reach a lower threshold than is currently in place, but does not seek to change the level at which a dark pool must provide access to its entire non-displayed book of orders. The monthly market share level that triggers a quote requirement for actionable IOIs would be dropped to 0.25 percent from the current 5 percent, but the 5 percent threshold for fair access would remain in place.
In addition, Colby noted that the Commission’s proposed dark pool rules require dark pools to give their subscribers more information about their pools. They would, for instance, have to be clear about "how orders interact and [that] what they’re telling their customers is accurate," he said. Colby suggested that the SEC is trying to "re-warn" dark pools that they must be more transparent to their customers. He added that evading various requirements based on technicalities wouldn’t likely go unnoticed.
In his discussion of broader regulatory issues yesterday, Colby also discussed flash orders, which the SEC proposed banning in September. Flash orders are marketable orders received by a market center that are shown to a group of participants or recipients of a proprietary data feed before being routed to another market quoting the industry’s best price. They are used by market centers to give firms potentially quicker fills and avoid sending orders to rival markets.
Colby pointed out that the SEC left open alternate ways to accomplish executions that are similar to flash orders but that do not raise the same regulatory issues about the potential creation of a two-tiered market. According to the SEC’s proposal, he observed, price-improvement mechanisms offered by exchanges would not be considered flash orders that would require display in the public quote stream.
The former SEC official said he didn’t see any reason why the SEC wouldn’t adopt a ban on flash orders, but noted that market centers would probably come up with auction mechanisms to replace them for customers that wanted to seek price or size improvement on a particular market center.
Colby also noted that some industry participants have observed that the SEC could have "interpreted the rule" that allowed flash orders, rather than seeking to amend it. The rule he referred to is the Quote Rule in Regulation NMS, which includes an exception for "ephemeral quotations" under which flash orders have been allowed. The decades-old exception, which dates from floor-based exchanges, allows verbal quotes to be excluded from the requirement to quote publicly.
More broadly, Colby noted yesterday that the SEC is looking at a range of market practices that have received scrutiny and public attention over the last six months. Some market participants, he noted, have been "pilloried by politicians and the press" even though they may have helped ensure that the equities and options markets could "trade in a way that hardly any markets were able to trade" during the financial crisis in 2008. Other markets, he said, did not function as well.
Colby noted that the industry needs regulators "to continue to look at what’s happening in an open, clear-minded review." There will always be "unfair arrangements, instances of abusive trading or unfair structure" during periods of rapid change, such as what the industry has been going through recently, he said. Changes in technology in recent years have altered the way trading occurs as well as the types of market participants that dominate the industry.
On a lighter note, Colby said, the financial industry’s choice of words to describe various practices may have skewed the public discussion of some of those practices. Industry executives, who have made this point many times in recent years, have decried the use of the term "dark pools." Colby quipped that "moonlit markets" might have sounded less ominous to people outside the industry.
And co-location, he added, could have been called "moving in with mom and dad." Co-location refers to the placement of a firm’s servers near the matching engine of a market center, to reduce the speed of executions and order cancellations. The SEC is also looking at whether co-location raises regulatory issues that need to be addressed.