Game Over Dark Pools? Here Comes Reg NMS-2

Tyler Durden's picture

"Has the era of the dark pool come to an end?" Thus begins the Traders Magazine cover article "End of the Line? SEC Targets Dark Pools and Off-Board Trading", which deconstructs all the incipient issues, criticisms and concerns facing the utterly discredited Mary Schapiro who is hell bent on getting at least one thing right during her career at the SEC, before she is brushed off as even less effective than her arguably much worse predecessor Chris Cox.

From the article (all highlights ours):

The Securities and Exchange Commission, spurred on by concern about two-tiered markets as well as criticism that it is not doing enough to level the playing field for ordinary investors, is expected to propose new rules this fall that could reduce the amount of trading done away from the public markets.

Sources tell Traders Magazine they believe the SEC will issue both an outright rule proposal as well as a "concept release" outlining possible changes to the way broker-dealers operate their dark pools. The SEC's concern is that too much volume is being done away from exchanges and electronic communication networks, and within the four walls of individual broker-dealers. That could hurt price discovery. In addition, allowing that to happen is seen, by some, as bad public policy because it short-changes those traders placing limit orders in the public markets and could hamper investors seeking the best available prices.

Currently, about 22 percent of all share volume is done off-board, including volume executed in dark pools. Whether that figure is too high for the SEC is not known. Any new rule proposal or concept release is likely to kick off a debate about how much volume, and what kind of volume, can acceptably be done away from the displayed markets without impacting price discovery.

Zero Hedge disclosed yesterday that just Goldman's SIGMA order routing system does roughly the same amount of trades daily as the entire NYSE.

And here is what the dire scenario for dark pool operators may very soon look like, if their worst fears become reality:

Imagine this scenario unfolding over the course of the next year: The SEC drops the threshold for dark pools to publicly display quotes and provide fair access from 5 percent to, say, 1 or 2 percent. It redefines dark pools, knocking out of commission those that are pure internalization engines for market makers. Automated indications of interest that zip around between dark pools and from dark pools to trading centers or other venues must be publicly quoted if the ATS triggers display requirements. All dark pools must count executions the same way and reveal more information about their trading activity after a suitable time delay, enabling broker-dealers to know how much of the market in particular securities is trading in particular ATSs. And finally, to continue the speculation, the trade-through rule gets a major tune-up that prevents dark pools (and possibly upstairs desks) from trading at the market's best price by simply matching that price. Instead, those pools would be required to take out the available displayed liquidity at the national best bid or offer before trading at that price.

This is truly a gloomy outlook for dark pools, as it effectively eliminates virtually all the benefits of dark liquidity aggregation and dissemination (to select insiders). As for the last point on taking out displayed liquidity at the NBBO, a topic first presented by Zero Hedge two months ago when we highlighted certain investment bank's concerns on the issue, this would be likely a critical first step to reestablishing open exchanges as true transactional venues, and potentially redeem some of the concerns that the investing public has had about increasingly nebulous market transparency and liquidity migrating to ATS venues.

And for once, it would appear that the SEC actually may mean business. Whether this is due to extensive lobbying efforts on behalf of certain exchanges is still unknown, but currently investigated by Zero Hedge staff.

The scope of what the SEC is considering is radical. Robert Greifeld, CEO of Nasdaq OMX Group, has referred to the prospect of change as "Reg NMS 2." He told analysts last month: "As we go into a period of time where there'll be renewed market structure discussions--it'll be Reg NMS 2--we have to make sure we take a comprehensive look at what's transpiring in the markets."

Greifeld himself isn't above stoking the fires. In a July letter to SEC Chairman Schapiro, Greifeld said his company "is concerned that the securities industry appears willing to accept more and more 'darkness' and limits on the availability of order information." He added that the goal should be "to eliminate any order types or market structure policies that do not contribute to public price formation and market transparency." He then laid out his wish list: "This would include not only flash orders, but the increasing use of 'dark pools,' internalization, and other venues in which the public is not permitted to participate fully."

Lawrence Leibowitz, head of U.S. execution and global technology at NYSE Euronext, laid the ground for those comments in a May speech when he said, "I think it's a good just revisit ATS and order-handling practices." He noted that while the equities markets held up extremely well throughout the financial crisis, "Our market structure has gone astray."

For exchanges, any rule-making that curtails off-board trading, and limits the ability of broker-dealers to internalize order flow through dark pools, is likely to benefit their markets. "Some level of liquidity is necessary for healthy price formation and a robust displayed limit market, said Joe Ratterman, CEO of BATS Global Markets, which operates BATS Exchange. "The SEC doesn't want information to get opaque again, transparency to disappear and have everybody trading in their secret little corners."

Yet no story would be complete without Goldman Sachs chiming in:

The operator of one dark pool is mixed about how much new regulation is necessary. "We think there are order-routing practices and other gaps that need to be closed," said Greg Tusar, head of U.S. electronic trading at Goldman Sachs Execution & Clearing. "But the market is as competitive as it's ever been, spreads are narrow, and transaction costs broadly have been in decline for years. That's benefited retail and institutional investors alike." He stressed that Goldman Sachs "doesn't believe that a massive reform is necessary and we'd caution against that."

Of course he would. After all Goldman broadly is at the nexus of not just open and dark trading venues, but is the monopoly provider of all client-facing and PB products that allow Goldman to have not just an unprecedented flow, but also a proprietary, informational advantage. And just in case there is any confusion which particular subset of the dark pool debate Goldman is leaning toward, let us remind readers that Goldman belongs to the "group [that] seeks to cross customer flow or enable internal desks or other liquidity providers to trade against that flow at the market's best price. A lot of traditional buyside flow comes to these pools through algorithms. Trades of the large-order variety typically go off at the midpoint of the national best bid and offer, while executions in big brokers' pools are often done at the best bid or offer, particularly for high-volume, penny-wide stocks. It is these pools that are likely to suffer the most if the harsher of any new rules come to pass." One wonders how long before Goldman's Hedge Fund devision, pardon, proprietary trading, is mandated to disclose their own P&L statement, instead of continuously commingling it with broader custoemr flow traffic.

1 % Thresholds and Actionable IOIs

Two primary action items facing the SEC are decision on reducing the ATS display threshold (currently at 5%) and whether to contain information leakage signals, aka Actionable IOIs, for those ATS that do hit the threshold. Curiously, only three key dark pool vendors would be impacted by a threshold reduction decision: Credit Suisse, GETCO and.... Goldman Sachs:

The 5 percent threshold, according to industry sources at broker-dealers and elsewhere, could be pared down to 1 or 2 percent. Others say 2.5 percent is more likely. That could happen in rule-making this year, or it could be part of a concept release that would kick the decision down the road.

Dropping the threshold to 1 percent would affect executions in many pools. Credit Suisse's CrossFinder, Goldman Sachs' Sigma X and Getco Execution Services are the only ATSs publishing volume figures that had more than 1 percent of consolidated volume in the last several months, according to Rosenblatt Securities. In individual securities, however, those ATSs as well as many others could easily account for a much higher share of consolidated volume.

It would appear threshold reduction is virtually a done deal at the moment:

Lindsey, the former SEC regulator, thinks that lowering the threshold is a good idea. "Reg ATS was meant to allow new technologies to be developed, not for people to fly under the radar," he said. "So lowering the threshold would make sense from that standpoint."

How about the dark pool rough equivalent of Flash Orders:

Orders in dark pools typically sit and wait for executions. However, some pools send out messages to other venues to rustle up contra-side liquidity. There has been uncertainty in the industry for a couple of years about whether these automated IOIs and other messages are actually quotes. That uncertainty is ending. James Brigagliano, co-acting director of the SEC's Division of Trading and Markets, has described IOIs that can be immediately hit or lifted as "actionable order messages" and has suggested that more specificity on this subject is coming this fall. Actionable order messages would have to be publicly quoted if a dark pool hits the ATS display threshold.

Why is this practically at the core of the issue?

Dark pools, of course, are built around the assumption that order flow won't be displayed, since doing so would expose the intentions of participants. Even if dark pools are executing small-size flow, displaying that information could cause customers to yank their orders and redirect them elsewhere. Trying to avoid triggering the display requirements would mean less liquidity and therefore less growth for dark pools.

Lastly, regulators are focusing on the issue of trading through the NBBO, and protecting displayed liquidity over non-displayed, which in essence is the primary way that dark pools game open exchanges:

At a market structure conference sponsored by the Securities Industry and Financial Markets Association in May, David Shillman, an associate director in the SEC's Division of Trading and Markets, observed that the Commission is now looking at a range of issues regarding off-board trading. "From a policy perspective, we are looking at whether we should take further steps to encourage displayed liquidity and see if dark interest is subverting the price discovery process," he said. "We would include both traditional market-maker internalization and dark pool activity in that analysis."  Shillman went on to raise the possibility of altering the trade-through rule in Reg NMS to encourage the display of more limit orders. He said the SEC may consider a prohibition on trading at the national best bid or offer unless the price-setting interest is first executed.

Right now, firms can match the NBBO and execute at that price level without having to execute against displayed liquidity. The ability to "quote-match" enables dark pools, upstairs desks and wholesalers to execute at the best price by simply matching that price. A trade-at prohibition would require firms to execute the liquidity available at the NBBO first, before trading at that price. If they didn't want to do that, broker-dealers could offer customers price improvement.

A prohibition on trading at the NBBO would cause dark pool volume to capsize. "The SEC has talked about the possibility that maybe dark pools shouldn't be allowed to match the price displayed in the displayed markets," White Cap's Selway said. "That would be a big change, since it would hold dark pools to higher standards, and possibly end the practice of dealer internalization via dark pool." Selway, however, thinks a trade-at prohibition is unlikely, especially if current industry discussions turn into a bigger debate about the value of internalization... "It's bad market structure to preference dark liquidity that doesn't improve on the spread," said Kim Bang, CEO of Bloomberg Tradebook, an ECN and broker-dealer. "In my opinion, we should prioritize those investors who choose to display their interest."

Yet not everyone, of course, is a fan of demolishing the market's two tiered structure:

Ratterman of BATS, however, doesn't like the idea of a trade-at prohibition for dark pools, even though dark pools siphon off liquidity from the displayed markets. "That uses a big fat sledgehammer of regulation to make it look like you can operate a dark book, [while] really making it, regulation-wise, so painful you stop trying," he said. "I think that limits functionality." He'd rather investors have more choice.

As the summer draws to a close, with just one market landscape casualty so far in the face of Flash Orders, the regulatory fall (no pun intended) is just starting. How and what the final outcome of the SEC will be on this next thorny issue of Dark Pools will in many ways determine the layout of the market for the next decade, and with it, the potential ever increasing monopoly presence of certain key players. While it is certain that Mary Schapiro will ultimately make a spate of bad (or worse) decisions, it is not too late for Christine Varney to finally start looking at these matters. Sooner or later she, and her anti-trust colleagues, will be thrust into this debate, voluntarily or not, and long after any proactive attempts to moderate it will have been long extinguished. Hopefully, complete investor trust does not extinguish alongside the SEC's continuing incompetence in all matters in which it is supposed to provide an expert and unbiased opinion.