The SEC is under pressure to review and reform high-tech trading practices to increase market transparency and ensure investor protection. Two specific areas that the SEC has focused on recently are dark pools and flash orders.
Dark pools are private trading systems in which participants can trade without displaying quotes to the public. They are useful for mutual funds that wish to execute large trades more discretely and with minimal market impact (helping to keep the cost of the trade down). In certain dark pools, when an investor wants to trade, an indication of interest (IOI), which may contain only certain pieces of information, is sent to members of the pool, others in its network or to only investors that can match the other side of the trade. IOIs are considered “actionable” when they contain enough information to permit others to trade immediately, thus functioning in much the same manner as displayed quotations.
The SEC has expressed concern over the growth of dark pools (which have tripled since 2002) and the lack of transparency that they create. Specifically, the SEC is concerned that dark pools create a two-tiered market that deprives the general public of information about stock prices and liquidity. Consequently, the SEC has proposed amendments to certain rules under the Securities Exchange Act of 1934 (the 1934 Act) to: (1) amend the definition of “bid” or “offer” to include dark pools’ actionable IOIs, thereby subjecting them to the same display requirements as other quotes; (2) lower the average daily trading volume threshold that triggers alternative trading systems (ATS), including dark pools, to display best-priced orders information to the public from 5 percent to 0.25 percent; and (3) require the same post-trade transparency for dark pools and other ATS as required for registered exchanges, including real-time disclosure of the identity of dark pools that execute trades. The proposals, however, would exclude “size-discovery IOIs” (IOIs related to orders of $200,000 or more that are communicated only to those who are reasonably believed to represent a contra-side trading interest of at least $200,000), which may leave funds with a viable means to continue to execute large orders through dark pools despite the proposed restrictions.
Flash orders, also known as “set-up orders” or “pre-routing orders,” permit certain market participants to see orders from other market participants a split second before the rest of the market. Currently, flash orders are exempt from certain requirements under the 1934 Act that require exchanges and ATS to provide their best-priced quotation to the consolidated quotation data that is widely disseminated to the public. The SEC has proposed an amendment to these requirements that would eliminate this exception and prohibit all markets, including equity and options exchanges, and ATS, from displaying marketable flash orders (a marketable flash order is a buy order priced at the national best offer and a sell order priced at the national best bid). As with dark pools, the SEC believes that the use of flash orders, in the context of today’s highly automated trading environment, may create a two-tiered market in which the general public does not have access, through the consolidated quotation data, to information about the best available prices.
The increased transparency that these proposals seek to create should benefit mutual funds and advisers by enhancing price transparency and providing a more accurate picture of the actual size of the non-displayed marketplace. Dark pools serve a useful role in the marketplace, however, and there is some concern that too much regulation could defeat the purpose of dark pools. The SEC’s focus on high-tech trading practices serves as a reminder that fund boards, with the help of advisers, should periodically review best execution policies in light of new technological trading developments, in order to better understand how trades are executed.
Copies of the releases proposing the amendments are available at: http://www.sec.gov/rules/proposed/2009/34-60997.pdf and http://www.sec.gov/rules/proposed/2009/34-60684.pdf.