Today the SEC voted unanimously to issue proposals designed to increase the transparency of so-called “dark pools” of liquidity, which are a type of private alternative trading system (”ATS”) in which participants can transact their trades without displaying quotations to the public.
According to the press release issued by the SEC earlier today, the SEC’s proposals generally would require that information about an investor’s interest in buying or selling a stock be made available to the public instead of just a select group operating with a dark pool, and that dark pools publicly identify that it was their pool that executed the trade.
How Do Dark Pools Operate?
When investors place an order to buy or sell on an exchange, the exchange typically makes that order available for the public to view. With some dark pools, however, investors are able to “signal” that they have an interest in either buying or selling a security. That so-called indication of interest (”IOI”) is communicated only to a subset of market participants.
Why the Current Focus on Dark Pools?
According to today’s press release and the SEC’s Fact Sheet on dark pools, the number of active dark pools transacting in stocks that trade on major U.S. stock markets has tripled since 2002, increasing from approximately 10 in 2002 to approximately 29 in 2009.
Given this growth of dark pools, the SEC is concerned that a lack of transparency could create a two-tiered market that deprives the public of information about stock prices and liquidity.
What are the SEC’s Main Concerns About Dark Pools?
Lack of Pre-Trade Transparency:
In most cases, before a trade is executed, a quotation generally is publicly displayed for other investors to see. But with dark pools, a participant’s IOI is conveyed only to selected market participants.
Such IOIs convey valuable trading information, and are deemed to be “actionable”, when they explicitly or implicitly inform the recipient about available trading interest at the dark pool with the best quoted prices or better.
The SEC is concerned that this practice could lead to a two-tiered market in which the public does not have fair access to information about the best available prices and sizes for a stock that is available to some market participants.
Lack of Post-Trade Transparency:
In most cases, after a trade has been executed, information about that trade is reported in the consolidated trade data that is widely disseminated to the public. But with dark pools, less information is conveyed. For instance, dark pools merely indicate that the trade was executed off an exchange, or “OTC”, and do not identify the particular dark pool that executed the trade.
The SEC is concerned that this lack of transparency detracts from the public’s ability to assess the sources of liquidity in a stock and dark pool trading activity in general.
How Would the SEC Proposals Address These Concerns?
1. To prevent the development of a two-tiered market in access to pricing information, the SEC’s first proposal would require that actionable IOIs be treated like a typical buy or sell quotation, subject to the same disclosure rules.
2. To further promote displayed liquidity, the SEC’s second proposal would lower the ATS volume threshold for displaying best-priced orders. Currently, an ATS, if it displays orders to more than one person, must display its best-priced orders to the public when its trading volume for a stock is 5% or more. The SEC’s proposal would lower that percentage to 0.25%, including for dark pools that use actionable IOIs.
3. To further enhance trading transparency, the SEC’s third proposal would create the same level of post-trade transparency for dark pools – and for all other ATSs – as for registered exchanges. Specifically, existing rules would be amended to require real-time disclosure of the identity of the dark pool that executed the trade.
Do the SEC Proposals Contain any Exceptions?
Exception for IOIs Related to Large Orders: The SEC’s first and second proposals would exclude certain narrowly targeted IOIs that are for $200,000 or more and that are communicated only to those who are reasonably believed to represent current contra-side trading interest of equally large size. These size discovery mechanisms are offered by dark pools that specialize in large trades, and, in the SEC’s opinion, can provide an efficient method for connecting investors desiring to trade shares in large blocks.
Exception for ATS Reports of Large Trades: The SEC’s third proposal would not apply to ATS reports of all large trades of $200,000 or more, in order to prevent the potential for the misuse of information about the buying and selling interest of investors engaged in such trades in a manner that would harm such investors.
What are Next Steps?
Full Text Release: The full text of the SEC proposals will be posted to the SEC web site as soon as it is available.
Comments: In its proposals, the SEC is seeking public comment and data on certain issues relating to dark pools.
Comment Period: The SEC will accept public comments for a period of 90 days after its publication in the Federal Register.
Final Note: Broader SEC Review of Equity Market Structure
In both its press release and its fact sheet, the SEC made the point of noting that dark pools of liquidity is one of several issues that the SEC is currently considering as part of its broad and ongoing review of equity market structure.
According to SEC Chairman Mary Schapiro:
“We should never underestimate or take for granted the wide spectrum of benefits that come from transparency, which plays a vital role in promoting public confidence in the honesty and integrity of financial markets. Today’s focus on dark pools is just one part of our broader ongoing review of how the equity markets are structured.”
