SEC Adopts Rule Proposal to Curtail Dark Pool Growth

The Securities and Exchange Commission today proposed a series of rule changes that would restrict communication between dark pools and, the Commission hopes, push more orders onto the displayed markets. The SEC commissioners voted unanimously to adopt the rule proposal, which the industry has anticipated for months.

Dark pools linked together through the use of actionable, or immediately executable, indications of interest "have access to information about a trade which other investors are denied," SEC Chairman Mary Schapiro said at a Commission open meeting this morning to consider the proposal from the Division of Trading and Markets. She noted that dark pools now represent a "significant source of liquidity in U.S. stocks" and that they risk creating a "two-tiered market that deprives the public of information about stock prices and liquidity."

To limit the growth of dark pools and push more flow back onto the public markets, the SEC proposed lowering the threshold at which quotes must be publicly disseminated to 0.25 percent of the average daily volume in a stock, from the current 5 percent. Dark pools represent close to 10 percent of the industry’s trading volume. Today’s rule proposal is likely to be open for public comment for 60 to 90 days, before the SEC makes a decision about the proposal.

Dark pools would also have to identify their prints to the consolidated tape in real time, including the name of the dark pool where the trade occurred, unless those prints have a market value of at least $200,000. This exception is meant to protect large size trades, since the disclosure of information about these trades could hurt the interests of those engaged in executing blocks.

This exception makes it likely that Liquidnet, which uses actionable IOIs for some of its trading, would be unaffected by the proposed rules. Pipeline Trading Systems and ITG Inc.’s Posit are unaffected by the proposed changes since they do not use IOIs.

The most significant change proposed by the regulator today involves a shift in what is considered a quotation. The SEC redefined automated messages that include order-like information resembling bids and offers as quotes. This change is significant since shifts in market structure in recent years have led to the fragmentation of dark liquidity. Some industry participants suggest that this fragmented liquidity has been re-consolidated by technology, including algorithms that execute in multiple venues and the use of actionable IOIs that link dark pools to one another.

The SEC, however, isn’t buying the argument about IOIs. James Brigagliano, co-acting director of the Division of Trading and Markets, said today that actionable IOIs "function quite similarly to displayed quotations and convey valuable price information, yet are privately transmitted to select market participants."

However, in a surprise move, the SEC did not define actionable quotes. Orders displayed to more than one entity at a time are typically considered quotes when they include information about the symbol, side, size and price. The Commission said it would offer the industry "guidance" that is more descriptive in nature about what constitutes a quote.

"We intentionally were results-oriented in our description, so we have the flexibility to look at what actually occurs and address new practices," said David Shillman, associate director in the Division of Trading and Markets. This is being done to prevent dark pools and automated liquidity providers from devising ways around any new definition of quotations.

Ian Domowitz, an executive at ITG Inc., said at a Baruch University conference yesterday that dark pool executions generally benefit investors. "By and large, the numbers speak well of dark pool executions," he said, referring to his firm’s studies of institutional transaction costs. ITG runs the Posit crossing system and other dark pools.

Gary Katz, CEO of the International Securities Exchange, said at the same conference that competition is driving some complaints about dark pools. Exchanges are complaining about dark pools because they’re "seeing prints that used to go to the exchange go to the dark pools," he said. Katz also noted that some of the order flow investors would like to interact with, including retail flow, often doesn’t make it to the public markets. "The good order flow has been removed," he said, because retail brokerages send marketable orders to wholesalers for quick executions that frequently offer price improvement over the national best bid or offer.

In today’s meeting, the SEC discussed the value of dark pools. Daniel Gray, senior special counsel in the Division of Trading and Markets, acknowledged that "there is evidence that dark pool trading can be efficient." At the same time, Brigagliano stressed the SEC’s aim in preventing two-tiered markets and avoiding disincentives to investors willing to display their liquidity.

Another big concern for the SEC is price discovery. Dark pools, by definition, offer derivative pricing based on quotes in the National Market System, which come from the public displayed markets. The SEC’s Gray noted that dark pools offer pricing based on public prices. "You don’t want to kill the goose that laid the golden egg," he said about the price discovery function of exchanges and ECNs.

The SEC expects the changes it has proposed to benefit price discovery and increase the displayed size on the public markets, including NYSE Euronext, Nasdaq and others. "We anticipate these proposals, if adopted, would promote additional liquidity and prices on the lit markets," Brigagliano said.

Commissioner Elisse Walter said that, in her view, every share crossed in the dark is potentially a share that does not assist in the public price discovery process. In addition, those trades, she said, prevent investors displaying their trading interest at the best price in public markets from achieving a "speedy execution."

Michael Gaw, an executive in the Division of Trading and Markets, said his division did not propose a 1 percent threshold for display requirements because "we’d still see a lot of game-playing by [dark pools] shutting off stocks." The lower threshold proposed by the SEC will cause dark pools to either go dark at the lower threshold or publicly display its quotes.

Not all dark pools currently send or receive actionable IOIs. Of the universe of roughly 30 equities dark pools, about a dozen use IOIs, Gaw said. Those pools would be most affected by today’s proposed rules.

Many dark pool executives have noted in recent months that volume executed in dark pools may not readily shift to the displayed markets if regulations change. In the view of some, dark interest will not turn bright if it cannot stay dark. The information leakage associated with displaying orders could make those operating in dark pools disinclined to switch to public markets.

Others also make the case that IOIs serve a function for investors that choose to use them. Leonard Amoruso, general counsel at broker-dealer Knight Capital Markets, said last week at a Security Traders Association conference that there are "very legitimate, very bona fide [reasons] why people are using IOIs" in dark pools. He noted that actionable IOIs are not likely to appear in the public quote stream if an ATS triggers the display requirements in Regulation ATS. Instead, he said, the behavior of market participants will change and the IOIs will disappear or be applied in other ways.

Dark pools, as they’re currently defined in Reg ATS, do not have any limits on their trading. Reg ATS specifies that indications must be publicly displayed when the dark pool’s average daily volume in a security reaches 5 percent (which today’s proposal would lower), and requires that an ATS trading 5 percent in a security provide what’s considered "fair access" to its liquidity. As a result, individual dark pools can continue to execute more than 5 percent of individual stocks as long as they’re truly dark and do not employ actionable IOIs.