On November 13, 2009, the Securities and Exchange Commission (the “SEC” or the “Commission”) published a proposal (the “Proposal”) to enhance regulation of so-called “dark pools of liquidity” (generally referred to as “dark pools”) – alternative trading systems (“ATSs”) that do not display quotations in the publicly disseminated consolidated quotation data.1 Given the lack of transparency inherent in much of dark pool trading, the SEC is concerned that an increase in such trading could deprive the public of important information regarding stock prices and liquidity. While the SEC recognizes that, over the years, liquidity has existed in various forms that did not provide price transparency or accessibility to all market participants, it is concerned that its rules have not kept pace with the increase in such trading resulting from technological advancements, leading to a conflict with the SEC’s longstanding policy to promote transparent markets.

Background

The term “dark pool” is not defined in the Securities Exchange Act of 1934, as amended, or in SEC rules. For purposes of the Proposal, “the term refers to ATSs that do not publicly display quotations in the consolidated quotation data.”2 In practice, dark pools are private trading systems in which a limited group of participants are able to execute trades without disclosure of their trading interest to the public. Some of the largest dark pools are sponsored by securities firms and are intended primarily for the execution of their customer and proprietary orders. Many of the dark pools have developed within the past decade to take advantage of technological developments and the SEC’s exemption of such trading venues from regulation as exchanges under SEC Regulation ATS.

As the SEC points out in the Proposing Release, dark liquidity is neither new nor especially exotic. Traders on exchange floors have long engaged in the practice of “working” large orders, executing them in numerous smaller transactions over a period of time in order to avoid revealing their entire interest and risking adverse price movements. Block positioners and over-the-counter market makers have traditionally performed similar functions. However, with the introduction of a high degree of automation to the process, and the proliferation of ATSs that provide dark liquidity functionality, the SEC is concerned about an increasing lack of transparency in the market.

Unlike exchanges, where orders to buy or sell securities generally are made available for public view, dark pools transmit order information electronically to a limited group of market participants, signaling a dark pool participant’s interest in either buying or selling a security. When such messages convey sufficient information for the recipient to immediately trade, they are referred to as actionable “indications of interest” (“IOIs”).3 But the fact that the dark pool participants’ interest in buying or selling particular stocks is made available only to a select group of market participants – those that participate in the particular dark pool – effectively reduces overall transparency in the market. This runs counter to the SEC’s long-held view that transparency is critical in assuring the efficient pricing of securities, maximizing depth and liquidity of the securities markets, and providing investors with the opportunity to receive the best possible execution of their orders.

According to the SEC, the number of active dark pools engaging in transactions in stocks that trade on major U.S. markets has increased from approximately 10 to approximately 29 in the past seven years, and the combined trading volume of dark pools during the second quarter of 2009 was approximately 7.2 percent of the total share volume in these stocks. The SEC is concerned that the increased use of actionable IOIs will lead to a “two-tiered” market in which not all market participants have the same access to information about available prices and liquidity.

Investors that do not participate in dark pools, and instead make their interest known only through public quotations and trade only in transparent markets, do not have access to the same information as those participating in dark pools. This access enables dark pool participants to have their orders filled even when similar orders displayed in publicly accessible markets remain unfilled. The SEC believes that there is an inherent unfairness in this result, especially given that dark pools use information derived from publicly displayed markets.

The Proposal

The Proposal seeks to achieve three main objectives: treating all quotes equally and subjecting them to the same disclosure rules; promoting a national market system and reducing market fragmentation by expanding the universe of trading platforms required to publicly display best-priced trading interest; and ensuring that the market price for stocks takes into account all available information. To achieve these objectives, the Proposal consists of three components:

  1. Amending the definitions of “bid” and “offer” in Rule 600(b) (8) of SEC Regulation NMS to apply expressly to actionable IOIs. Because this definition determines the public quoting requirements for exchanges and OTC market makers under Rule 602 of Regulation NMS, and those for ATSs under Rule 301(b) of SEC Regulation ATS, the new definitions would subject actionable IOIs to the same disclosure rules as other quotes.
  2. Amending Rule 301(b) of Regulation ATS to lower the threshold at which an ATS is required to publicly disseminate its best-priced orders for a National Market System (“NMS”) stock. Currently, an ATS is required to disseminate bestpriced orders if its average daily trading volume for an NMS stock is 5 percent or more of the stock’s overall average daily trading volume during four of the preceding six months. However, the SEC has found that very few ATSs exceed this threshold. The Proposal would lower this threshold to 0.25 percent of the stock’s average daily trading volume. The SEC also proposes to amend Rule 301(b)(3)(ii) of Regulation ATS to make the display requirements applicable to all orders. Currently, the display rules under Regulation ATS only require orders that are displayed to more than one person in the ATS to be displayed. The proposal would make the display rules applicable whenever an order is displayed to more than one person (other than employees of the ATS), regardless of whether such persons are participants in the ATS.
  3. Amending the existing joint-industry transaction reporting rules to require post-trade disclosure of the identity of the ATS on which each trade is executed. This requirement would apply to trades by all ATSs, not just dark pools. The Proposing Release notes that exchanges currently are required to be identified in this manner, and that the Proposal would equalize the reporting requirements for exchanges and ATSs.

The Proposal provides exceptions for orders, IOIs and transactions with a market value of $200,000 or more that are displayed to those who are reasonably believed to represent a current contra-side trading interest of at least $200,000. This is designed to enable institutional investors to effect large trades with appropriately sized counterparties without disclosing price information to the market, which can negatively impact the price of the stock before a trade can be executed.

The Commissioners’ Views

The SEC first announced the proposals at an open meeting on October 21, 2009. Although the Commissioners voted 5-0 to publish the proposals for comment, their views were far from unanimous. Chairman Schapiro stated that transparency plays a vital role in promoting public confidence in the honesty and integrity of the markets, and that the SEC must preserve the essential role of the public markets in promoting efficient price discovery and investor confidence. Commissioner Casey, while supporting a request for public comment on the Proposal, cautioned on the need to avoid rushing to regulate without completely understanding the extent to which complex and dynamic activities are interrelated. She also called for such decisions to be driven by objective data rather than politics and unfounded assumptions. Commissioner Walter expressed support for the Proposal as a means to improve the quality of information about NMS stocks, and noted that when trading interest in dark pools is not included in the public quote stream, price discovery can be impaired and investors lack accurate and complete information about best prices. Commissioner Aguilar supported the proposal because of his concern about two-tiered access to information, but expressed support for an exception for large orders, recognizing that requiring institutional investors with large orders to disclose the size of their interest would render them vulnerable to being taken advantage of by other market participants. Commissioner Paredes expressed “significant reservations” about regulating discreet aspects of market structure without first undertaking a comprehensive review of market structure as a whole. He suggested deferring the dark pool issue and addressing it in the context of a broader concept release that the SEC is expected to issue covering market structure issues.

Request for Comments

In proposing to regulate dark pools, the SEC’s primary goals are increased transparency and avoiding a two-tiered market that deprives some market participants of complete information about stock prices and liquidity. These concerns are virtually identical to those expressed in the Commission’s proposal to eliminate the exception for “flash orders” from the public quote dissemination requirements.4 However, as with the flash order proposal, the Commission recognizes that there are significant countervailing interests, particularly those of institutional investors wishing to trade large orders without the negative impact on their positions that could result from full disclosure of the size and price of their trading interest to the entire market.

The SEC is requesting comments and data on all of the issues relating to the Proposal, including whether amending the definitions of bid and offer to apply to actionable IOIs would promote transparency, fairness, and efficiency in the national market system, and whether it would promote fair competition among trading venues in NMS stocks. The SEC also asks whether the rule text should include an express definition of the term “actionable IOI” and, if so, what that definition should be, as well as whether the large order exception is appropriate. Among the questions asked with respect to the proposed reduction of the threshold for triggering the Regulation ATS order display and execution access requirements is whether the proposed 0.25 percent threshold is appropriate or whether there should be a higher or lower threshold. The SEC also asks whether the proposal to require disclosure of the particular ATS that executes a transaction is the best way to address the issue of improving ATS post-trade transparency.

Comments should be submitted so that they are received on or before February 22, 2010.

Next Steps

In addition to seeking comment on the Proposal, the SEC also is considering further examination of the issue of dark liquidity and the potential effects of permitting some indications of trading interest to be made available only to select market participants. For example, on October 28, 2009, in testimony before the Senate Banking Subcommittee on Securities, Insurance, and Investment, James Brigagliano, Co-Acting Director of the SEC Division of Trading and Markets, said that in the coming months the SEC may consider additional issues relating to dark pools, and may issue a “concept release” that addresses the subject — a point also made by Commissioner Paredes at the SEC’s open meeting. The Proposing Release likewise alludes to the SEC preparing a concept release to address a wide range of market structure issues, noting that the Proposal does not address all of the issues regarding dark liquidity.

Interestingly, those dark pools that truly are dark (i.e., do not communicate actionable IOIs to participants) would not be affected by the proposed changes to the definitions of bid and offer, and the trading interest in those dark pools would remain invisible to the public. While the Proposing Release requests comments on this point, including whether dark pools that currently use actionable IOIs might cease doing so in order to avoid the impact of the Proposal, consideration of the overall market impact of trading in dark pools may have to wait for the concept release, along with consideration of matters such as high-frequency trading and other market structure issues.

Regulators in other countries also are raising concerns about dark liquidity. For example, regulators in the European Union have announced that they expect to complete a review of dark pool trading by year-end, which could result in regulations to control or curtail the practice. It will be interesting to see whether any of their findings are reflected in future SEC releases.