If the Securities and Exchange Commission revisits aspects of Regulation ATS this fall, as some expect, Liquidnet’s exemption to the fair-access requirement could be on the chopping block.
Liquidnet’s business could take a significant hit if its exemption disappears altogether. However, few expect this would happen without additional regulatory changes that would enable the crossing platform to keep doing business.
"Lowering the threshold [for us] would be problematic," said Howard Meyerson, general counsel at Liquidnet. "Our system is a useful way for institutions to reduce their trading costs. Telling institutions they have to go to block traders would set the market back 10 years and take away tools that institutions use to execute their orders efficiently."
Mark Wright, global head of product management at ITG Inc., which runs the POSIT crossing system and which competes with Liquidnet, thinks its rival should not have its exemption yanked. "We believe many of the arguments Liquidnet put in its letter [requesting an exemption from the fair access requirements]–about why certain dark pools should guard access to their pool and keep predators out to protect institutional customers–are useful," Wright said. "If the SEC changes the threshold, even in this day and age, the SEC would presumably still grant exemptions."
Liquidnet received a limited exemption to the fair-access requirements in September 2005 when the SEC lowered the threshold to 5 percent, from 20 percent, in connection with Regulation NMS. The exemption requires Liquidnet to provide fair and non-discriminatory access to trading in a specific stock on its platform if it executes 20 percent of that stock’s average daily volume in four of the previous six months. All other alternative trading systems are subject to the SEC’s current 5 percent threshold.
Reg ATS, which became effective in 1999, established a regulatory framework that enabled broker-dealers to create trading systems that competed with exchanges. It requires ATSs to disseminate their best priced quotes in a particular stock into the public quote stream once they reach 5 percent of the volume in that name. It also requires them to provide fair access to their markets once they represent 5 percent of the volume in a stock.
Liquidnet based its exemption request on the argument that it performed a similar task to upstairs desks seeking contra-side liquidity for buyside clients’ block orders. Block desks are generally not subject to the fair-access rule. The firm also said that restricting access to just institutions was a key element of its business model.
In granting the exemption, the SEC appears to have, at least implicitly, agreed with that argument. The Commission also noted that "In particular, since Liquidnet does not disseminate quotations, applying the new 5% fair access threshold to Liquidnet would not further the Commission’s primary policy goal in lowering the threshold, namely facilitating indirect access to the quotes of ATSs that are displaying them in the public quote stream." Liquidnet does not send what the SEC considers quotes to institutions or other ATSs.
The SEC is now in the process of conducting a broad overview of dark pools and non-displayed liquidity. As part of this review, the SEC, according to a half-dozen market participants who spoke with Traders Magazine, is weighing the idea of further lowering ATSs’ fair-access threshold for individual stocks. What’s on the table is a 1 or 2 percent threshold. The SEC declined to comment.
For Liquidnet, a lowering of its higher threshold would hurt Liquidnet’s business. The firm, for instance, does not allow broker-dealers to trade on its main system. Fair access would allow brokers to rush in, compromising the firm’s business model and attractiveness to institutions.
Liquidnet regularly approaches its 20 percent threshold. "In a typical month, we might block trading in a few stocks," Meyerson said. Liquidnet and other ATSs that approach the threshold for fair access and quotation display for particular stocks typically shut off trading in those names to avoid triggering the requirements. (The display threshold is 5 percent for all ATSs, although platforms like Liquidnet that don’t display quotes are not affected by that requirement.)
Liquidnet may trade only a few stocks that get close to 20 percent over the course of months, but many trade more than a few percentage points of their ADV on a monthly basis. In July, Liquidnet traded a daily average of 37.6 million shares (double-counted) on its main negotiation platform.
However, many in the industry consider it unfair for individual platforms to get exemptions. Jamie Selway, managing director of institutional broker White Cap Trading, for instance, thinks that if the SEC cranks down the threshold for fair access and the display of quotes, it should not allow exemptions for specific systems. Instead, he said, the rules should be crafted to exclude trading behavior, such as block trades, that the SEC doesn’t want to catch in the threshold net, rather than hand-picking individual systems to exempt.
Selway stresses that launching a broader discussion about fair access also runs the risk of potential collateral damage to crossing platforms. "What would be bad for investors is if Reg ATS 2.0 wound up hurting Liquidnet and block pools," Selway said. "Transaction costs for institutions would go up." The Reg ATS 2.0 comment referred to the prospect of new rules that could affect non-displayed systems.
Liquidnet’s Meyerson recognizes the concern about individual systems receiving exemptions. "Rules should be based on the type of system you are, not the specific system," he said. He believes the SEC should extend equal treatment to manual block trading desks and electronic block trading facilities. Another important principle, he said, is that the same rules shouldn’t be applied to markets trading 250 shares at a time and those trading blocks of tens of thousands of shares, which have different needs.
In his view, there are regulatory alternatives to individual exemptions. "I don’t think block orders should count against the fair-access threshold," Meyerson said. "Block orders have different needs than 200-share orders."
Other block platforms such as Pipeline Trading Systems and ITG’s Posit aren’t in the same boat as Liquidnet. ITG’s Wright notes that Reg ATS itself contains "carve-outs" to the fair-access requirements. Systems that match customer orders, that don’t display order information to anyone outside employees of the ATS company, and that execute orders at prices derived from publicly disseminated prices are not subject to the fair-access provisions. ITG and Pipeline Trading Systems both qualify for the carve-out. Most dark pools do not.
Liquidnet doesn’t qualify for the carve-out since it displays order information to one buyside trader at a time. In addition, participants are allowed to negotiate the price within the national best bid and offer, even though 86 percent of its volume is executed at the NBBO midpoint. Meyerson noted that these elements of its system made it ineligible for the current carve-out within Reg ATS.
The SEC has stressed that its concern about dark pools, whose average execution size is in the hundreds of shares, doesn’t extend to block systems that enable institutions to trade in size. In recent months, SEC Chairman Mary Shapiro has said several times that she recognizes the need for institutions to trade away from the displayed markets. "We have to be conscious of the fact [that] there are very large trades that have to be accomplished in the marketplace, akin to the old block desks in investment banks," she told CNBC last month. "We have to think about that and how that translates into this new, very technologically empowered trading market that we have today."
ITG’s Wright said the message seems to be coming through. "The SEC has given no signal that true dark pools servicing institutions, such as what we operate, would have new fair-access requirements," he noted. "We truly believe that these pools serve an important function in the marketplace."
