The Securities and Exchange Commission is considering a significant change related to Regulation ATS that could ultimately shrink dark pool volumes.
Specifically, the SEC is considering whether to lower the 5 percent threshold at which alternative trading systems must display quotes publicly and provide "fair access" to their markets, according to a number of market participants. This, coupled with firming up the industry’s understanding of certain types of automated messages designed to seek liquidity, could reduce dark pool market share.
The SEC is reviewing the idea of decreasing the market share threshold that triggers display and fair access requirements to 1 to 2 percent, from 5 percent, industry sources told Traders Magazine. Some industry executives familiar with the SEC’s discussions expect the threshold level to be cut to 2.5 percent. Any change to this requirement in Regulation ATS would involve rule-making subject to a public comment period. That rule-making could occur as early as this fall. The SEC declined to comment.
Jamie Selway, managing director of institutional broker White Cap Trading, said he expects the SEC to seriously consider pushing the threshold down to 1 percent. He thinks the SEC is leaning toward lowering the standard, but believes there will be industry pushback. He doesn’t have a strong view on what the SEC will do, he said.
Dan Mathisson, head of Advanced Execution Services group at Credit Suisse, said his firm has had discussions with the SEC about the display and fair access requirements in Reg ATS. "Lowering the threshold appears to be on the table," he said. "We’re thrilled the SEC is reviewing this issue. We’re hopeful they’re going to make a change."
"This would be a radical change," Selway said. "If you’re a dark pool of reasonable size and you’re exchanging order information through what are essentially limited private networks, you’d incur quote obligations. That would probably kill the practice of routing out order-ish messages." He added that dark pools would have a harder time going "semi-light" to pursue more executions.
Many dark pools currently send out automated messages based on orders to other pools or venues to find contra-side liquidity. If dark pools don’t send out those messages or electronic "indications of interest" to seek liquidity elsewhere, they may have a harder time growing their volume.
Currently, if a dark pool trades 5 percent of the average daily volume in a stock in four out of the last six months on a rolling basis, it must publicly display its quotes and provide "fair access" to its liquidity pool. Dark pools typically attract flow from customers who do not want to display their orders in the markets because of market-impact concerns. If a pool is required to display quotes, the incentive to use that pool is likely to decrease for many customers. Providing that information publicly could increase the prospect of information leakage on orders sent into the pool.
Dark pools can avoid quote obligations once they hit the quoting threshold if they send participants non-firm "indications" (rather than orders) that are intended to produce a negotiation. They can also send quotes to just one participant or customer at a time. Alternately, a pool could stop trading a particular name before reaching the threshold to avoid triggering the quote obligation. Orders sitting in dark pools waiting passively for a match do not have to be displayed.
Credit Suisse’s Mathisson said his firm would like to see the fair access threshold decrease. "We think it’s long overdue," he said. "For years ATSs have been able to exclude others from the game. That’s not healthy." However, he said, other changes to Reg ATS would also be necessary to make it easier to reach pools that must provide broader access.
SEC Chairman Mary Schapiro said last week in a CNBC interview that the SEC recognizes the importance of being able to execute large trades through non-displayed markets. "I do think we have to be conscious of the fact there are very large trades that have to be accomplished in the marketplace, akin to the old block desks in investment banks," she said. "We have to think about that and how that translates into this new, very technologically empowered trading market that we have today. We’ll be thinking about the market structure."
In June, according to Rosenblatt Securities, the only ATSs that exceeded 1 percent of consolidated volume were Goldman Sachs’ Sigma X, Credit Suisse’s CrossFinder and Getco Execution Services. (Knight Link, a dark liquidity product offered by market maker Knight Capital Group, is not an ATS.) However, those pools as well as many others could have a much higher market share in individual names.
The possibility of this change to Reg ATS comes as the SEC is conducting a broad review of dark liquidity and dark pool practices. The SEC has expressed concern about issues related to fragmentation and investor access to significant non-displayed liquidity pools. The SEC is also looking at what type of information dark pools route to one another and those routing practices.
For the SEC, the ability of dark pools to route order information to one another has lifted a barrier to the growth of dark pools generally. If dark pools route to one another to electronically seek liquidity, and do not simply match orders within their own pools, fragmentation does not have a natural check. There are currently several dozen ATSs, although some may not do much volume.
"Actionable order messages…are used by the operators of dark pools to alert users when they have liquidity and thereby may weaken [the] competitive force for consolidation, James Brigagliano, co-acting director of the SEC’s Division of Trading and Markets, said in a May speech. "If actionable order messages enable many small pools to survive separately, market fragmentation could worsen."
On the routing front, Jonathan Kellner, president for North America of institutional broker Instinet, notes that what is considered a quote is an important issue in the industry. "It’s a complicated environment and it can be tough to define what’s an order, what’s an IOI, what’s a quote," he said. "If that was clearly defined, there would be a more level playing field."
Many in the industry say the SEC hasn’t provided enough clarity about the differences between a quote and an order. However, the SEC is now doing this. Brigagliano in May described orders that can be immediately hit or lifted as "actionable order messages."
He noted that dark pools have different names for various messages they send one another in pursuit of liquidity, but that, for the most part, they are the equivalent of quotes. "Given the speed and sophistication of today’s order routing and trading systems, it appears that private actionable order messages are functionally and economically similar to public quotes," Brigagliano said in May. "The systems are incredibly fast–both actionable order messages and quotes can be transmitted and responded to within a few milliseconds. Although a public quote always will have an explicit price, an actionable order message is implicitly executable at the NBBO or better." Dark pools must execute at the NBBO or better.
Other regulators have stressed, over the last couple of years, that if an automated message includes side, size and price information, it’s a quote. Still, industry confusion about the definition of a quote in an automated non-displayed trading environment has remained.
