The Securities and Exchange Commission’s proposed rules for dark pools, published last Friday, attempt to level the playing field between dark pools and displayed markets. The SEC is doing this to ensure that relevant information about quotes and trades that investors need to make trading decisions is publicly available.
"The Commission believes that broker-dealers operating [alternative trading systems] should be subject to quoting requirements that broadly parallel those applicable to other market participants," the regulator said in its proposal, referring to exchanges and electronic communications networks. The SEC said this change could also roll back some of the fragmentation that has taken place in the equities marketplace. This could happen if more order flow winds up in the displayed markets and quotes disseminated by dark pools join the public quote stream, ensuring easier access to more price information.
The rule proposal imposes new, tighter quoting requirements on dark pools that disseminate "actionable indications of interest," which the SEC says are functionally equivalent to quotes. Those pools must either stay completely dark or incorporate the quotes they disseminate (beyond a small amount) into the public quotation data. The proposal also requires dark pools to identify their venues when they print trades. Two of the three changes in the proposal address quoting issues, while the third tackles post-trade reporting of dark pool executions.
For some in the industry, this proposal doesn’t go far enough in trying to ensure that dark pools stay dark and do not disseminate actionable IOIs. Andrew Silverman, head of electronic trading distribution at Morgan Stanley, has argued for more than a year that actionable IOIs result in information leakage on large orders. He welcomed the proposal but wants stiffer rules.
"The proposal spoke about pools that send out IOIs," Silverman said. "But a broker can send an IOI from a dark pool, from a smart order router, or from an algorithm. If the SEC just focuses on sending out IOIs from dark pools, brokers can shift [what they do] and send them from their smart routers. That’s a hole that will have to be addressed."
Silverman said Morgan Stanley’s dark pools won’t be affected by the new proposed display requirements. "Our dark pools will largely be unaffected because our dark pools, as well as our order handling infrastructure more generally, are truly dark," he said.
The public can comment on the SEC’s 116-page rule proposal on "non-public trading interest" for 90 days after its publication in the Federal Register. The SEC must make a final decision about these rules before they go into effect.
The rule proposal largely conforms to industry expectations about what would be included. SEC executives had publicly discussed some of their plans for dark pools over the last half-year, and provided more information in a public meeting last month. At that meeting, the SEC commissioners unanimously approved the issuance of the proposed rules. The rules were published on the SEC’s web site on Friday.
These proposed rules are far from the end of the SEC’s focus on dark pools. The SEC said it plans to broaden its query of dark pools in a concept release due out early next year. That document will probe "the benefits and drawbacks of dark liquidity in all its forms, including dark pools, the order flow arrangements of OTC market makers, and undisplayed orders on exchanges," according to the SEC.
For now, though, the SEC honed in on three rule changes. It proposed amending the definition of a bid and an offer in Regulation NMS to limit the exclusion of indications of interest to only block IOIs, or what the SEC calls "size discovery IOIs." This change means that what the SEC calls actionable IOIs would be deemed quotes and subject to quote display requirements in Regulation ATS.
The SEC said an IOI would be deemed actionable if it explicitly or implicitly conveys information about symbol, side, price and size. The latter two can be implicit, since trades must execute at the NBBO or better, and the presumed size is for at least one round lot. Once that information must be quoted publicly, however, the implicit information would have to be made explicit.
The second proposed change is to lower the trading threshold that triggers quote display requirements for dark pools to 0.25 percent, from the current 5 percent. Those quotes would have to be publicly displayed and accessible once a dark pool trades 0.25 percent of a stock’s monthly average daily volume, for four of the previous six months.
The goal of providing consolidated quotation information "is not met when dark pools or other trading venues disseminate information that is functionally quite similar to quotations, yet is not included in the consolidated quotation data," the SEC said. It added that the it is also concerned that the "private use of actionable IOIs may discourage the public display of trading interest and reduce quote competition among markets."
The Commission went on to note that IOIs that attract liquidity to particular dark pools could divert flow from the public markets. The SEC said it wants that flow to contribute to the price discovery process. Reducing the threshold thus reduces the "amount of important price information that is selectively displayed outside the public quote stream."
The SEC’s third change involves post-trade reporting. The Commission proposed mandated real-time disclosure of the identity of the ATS where prints occur. This means public trade data would specify the dark pool where prints occurred.
This measure is intended to even the playing field between ATSs and exchanges. The SEC referred to differences in the post-trade reporting requirements of ATSs and exchanges as an "information gap." The post-trade reporting change, the SEC said, is designed "to improve the quality of information about sources of liquidity in NMS stocks" and to "equalize the trade reporting requirements for exchanges and ATSs, both of which operate systems that bring together orders of multiple buys and sellers on an agency basis."
Currently, about 38 percent of the industry volume is reported as OTC trades. This includes dark pool trades, ECN volume and upstairs trades. But the lack of post-trade information, particularly as the market share of the New York Stock Exchange and Nasdaq have declined in recent years, worries the SEC. "The lack of information concerning the ATS on which trades are executed makes it difficult, if not impossible, for the public to assess ATS trading in real-time, and to reliably identify the volume of executions in particular stocks on individual ATSs," the SEC said.
The SEC observed that dark pools disseminating quotes can avoid the burden of its proposed display obligations by staying completely dark and not disseminating quotes. If they choose to display their quotes, the SEC said, they could do so through FINRA’s Alternative Display Facility or at an exchange that provides order delivery functionality, as is currently the case for ECNs.
At the same time, the SEC is recognizing the importance of block executions in the dark, which SEC Chairman Mary Schapiro has repeatedly stressed in recent months. It provided an exception to the display and access requirements for a dark pool’s quotes for what it calls "size discovery indications." These are indications for orders with a market value of $200,000 that are sent to potential counterparties with similar block sizes. The SEC also excluded block indications of the same size from its new proposed definition of bids and offers in Reg NMS. And dark pools reporting trades with a market value of $200,000 or more would not have to be identified on the tape. These trades could continue to be reported as OTC trades.
Tony Barchetto, head of sales strategy at Liquidnet, a block dark pool, said his firm was pleased the SEC "acknowledged the difficulty of institutions trading in size. That’s definitely a positive." Liquidnet operates two ATSs, one for blocks and one for blocks and algorithmic flow.
He said Liquidnet would likely file a response to the proposal with a number of suggestions. The $200,000 exception for displaying quotes, Barchetto said, might be too large for many block orders, particularly for small-cap stocks. In addition, he said, an exception only for block-size trades "might be inflexible." He noted that many ATSs trade blocks that have been broken down into smaller orders, making information leakage a concern for those orders as well. Under the SEC’s current proposal, Liquidnet H2O, the firm’s streaming liquidity pool, would be affected by the display requirements for actionable IOIs.
Other brokers have made similar arguments about executed block trades. Executives from Goldman Sachs and Credit Suisse have suggested at recent conferences that "virtual blocks" that have been broken down into smaller trades should be immune from post-trade transparency requirements now being planned for dark pool executions.
The real-time identification of the dark pool when ATSs trades print is an issue many in the industry feel strongly about. Although some market participants think the industry would adapt to real-time requirements, others think institutions would be irreparably hurt and could shy away from dark pools, limiting their ability to execute blocks quietly.
On an Investment Company Institute webinar about market structure issues yesterday, Kevin Cronin, global head of equity trading at Invesco, said he would be concerned about real-time disclosure of an ATS’s identity in trade reports. High-frequency traders and others trying to sniff out institutional flow are likely to use that information to fuel their strategies, which often seek to profit at an institution’s expense, he said.
At a Senate banking committee hearing on market structure late last month, Dan Mathisson, head of Advanced Execution Services unit of Credit Suisse, argued that real-time disclosure of ATS executions would benefit primarily high-frequency trading firms and hurt institutional investors. Peter Driscoll, senior equity trader at Northern Trust and chairman of the Security Traders Association, agreed, noting that end-of-day disclosure of the pool should be sufficient transparency to aid investors without hurting institutions.
By and large, the SEC’s proposed rule revisions for dark pools are likely to benefit the displayed markets. Exchanges and ECNs are expected to benefit by seeing some more order flow come their way and by the limitations on the ability of dark pools to grow by disseminating actionable IOIs.
However, the proposed rules did not go as far as NYSE Euronext and Nasdaq OMX Group might have liked. In recent months, the two exchange operators have pushed for more dark pool regulation. Duncan Niederauer, CEO of NYSE Euronext, said last month that exchanges and dark pools should compete on a "level playing field." Dark pools, he said, should have "similar rule-making processes and regulatory standards" as exchanges so they don’t get a leg up on their displayed cousins.
Still, the exchanges are likely to profit from the SEC’s stricter approach to dark pools. Referring to the pending changes involving dark pools, Robert Greifeld, CEO of Nasdaq OMX, said last month that the "regulatory discussions ongoing right now will certainly be a significant net positive to Nasdaq OMX."
