October 28, 2009
Previously published on October 23, 2009
On October 21, 2009, the U.S. Securities and Exchange Commission (“SEC”) voted unanimously to propose rule changes (the “Proposal”) that would subject so-called “dark pools of liquidity” (“Dark Pools”) to greater data dissemination requirements by dramatically reducing current exemptions from order display requirements under Regulations NMS and ATS.
A Dark Pool primarily functions to provide large institutional investors with a crossing system that allows them to trade blocks of shares without revealing themselves to the open market and exposing themselves to the attendant risks of front-running, shadowing and other forms of price disruption. Typically Dark Pools are anonymous and do not feed into the consolidated national best bid or offer quotes available to all investors. In a typical arrangement, Dark Pools allow their participants to enter an indication of interest (“IOI”) that will “ping” other participants. Some Dark Pools also send IOIs to other Dark Pools in order to improve liquidity and increase the sending Dark Pool’s executions.
A Dark Pool is a type of “alternative trading system” (as defined in Regulation ATS) (“ATS”) that is excluded from, among other things, the order display and fair access provisions of Rule 301 of Regulation ATS. Under the present regulatory framework, a Dark Pool stays “dark” because, among other reasons, the meaning of “bid or offer” under Regulation NMS excludes an “indication of interest” (indications of interest are also excluded from the definition of “quotation”). Furthermore, Regulation ATS now exempts an ATS from, among other things, the requirements to display its highest buy price and lowest sell price to the national exchanges and provide equivalent execution access to broker-dealers on the same national exchanges. This exemption currently applies so long as, during at least four of the preceding six calendar months of any given date, the ATS maintains an average daily trading volume of less than 5 percent of the aggregate average daily share volume for a given security.
The SEC has recently come under pressure from traditional exchanges such as the NYSE and by legislators, most notably Senator Charles Schumer (D-New York), to amend existing regulations to increase transparency of Dark Pool trading data. Among the criticisms that have been leveled against Dark Pools are that they create a “two-tiered” market that gives some institutional investors an unfair advantage over other investors who are not participants in those Dark Pools, especially with respect to the use of actionable, or immediately executable, IOIs between Dark Pools. Dark Pools are also alleged to divert an increasing number of smaller trades from the open market, which, it is claimed, undermines the accuracy of public quotes. Finally, Dark Pools are argued to provide little or inconsistent trading-volume data to the public, due to a lack of uniform reporting standards.
Accordingly, the Proposal would significantly claw back the regulatory exemptions available to Dark Pools by implementing the following rule changes:
- Amending the definition of “bid or offer” under Rule 600(b)(8) of Regulation NMS to explicitly include actionable, or immediately executable, IOIs (note, however, that the SEC did not define what would constitute an actionable IOI under the Proposal);
- Amending the average daily trading threshold contained in Rule 301(b)(3) of Regulation ATS from five percent to one-quarter of 1 percent (0.25%), which percentage will become the threshold for both order display and execution access requirements; and
- Adding the obligation to make real-time disclosure of the identity of a Dark Pool on the public reports of its executed trades.
The Proposal provides exceptions for any transaction with a market value of $200,000 where there is a reasonable belief that the contra-side trader has interest in at least a $200,000 market value transaction. These exceptions would apply to many institutional investor transactions, and would continue to serve what the SEC expresses is a valid purpose of Dark Pools, namely to provide institutional investors with a means of trading large blocks of shares without risking price disruption.
Based on information provided at the open meeting, it appears that the Proposal will be focused on enhancing transparency of Dark Pool quotes and trade execution, but will not affect the pre-trade or post-trade anonymity of individual Dark Pool participants.
The Dark Pools Proposal follows a September SEC proposal to eliminate Flash Orders, a feature in some ATSs that allows participants to show an order available for immediate execution to other participants in the ATS without revealing the existence of that order to the broader market. A Flash Order typically is cancelled if it is not immediately executed, and the SEC expressed similar concerns that these orders undermine the transparency of the markets. SEC Commissioners and senior staff have indicated that the Flash Order and Dark Pool proposals are part of a broader review of securities market structure which may include sponsored or direct access to exchange and ATS trading platforms, high-frequency trading, and co-location.
Public comments on the Proposal (the text of which is not yet publicly available) must be submitted to the SEC within 90 days of its publication in the Federal Register.
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