Speech by SEC Commissioner:
Statement at SEC Open Meeting to Propose Amendments Regarding the Regulation of “Dark Pools”
Commissioner Troy A. Paredes
U.S. Securities and Exchange Commission
October 21, 2009
Thank you, Chairman Schapiro.
Concerns have arisen about “dark pools.” For instance, actionable indications of interest (IOIs), when made available to select market participants, have been said to contribute to the creation of a “two-tiered market.” In addition, dark pools have been criticized for discouraging the public display of liquidity.
In response to these concerns, the rule proposal before us would subject dark pools to additional regulation by: (1) providing that an actionable IOI, other than an IOI that reflects trading interest worth $200,000 or more, constitutes a quote; (2) lowering the volume threshold at which an ATS must publicly display quotes for an NMS stock from the current threshold of 5% of average daily trading volume in that stock on the ATS to 0.25%, subject to an exclusion for orders worth at least $200,000; and (3) requiring the real-time public disclosure of the actual dark pool or other ATS where a trade was executed, except that disclosure would not be required for a large trade of $200,000 or more.
Dark pools present certain challenges but also benefit investors, including retail investors, and our markets generally in important ways, such as by lowering trading costs, providing market participants more choice, and spurring competition among trading venues. Accordingly, dark pools deserve thorough consideration. To benefit from the comments — which hopefully will include data — that the Commission will receive, I am willing to support the recommendation. However, I have significant reservations.
Markets are complex systems comprised of numerous components and features that must work together to ensure a well-functioning “whole.” I am concerned that by taking steps now to regulate particular aspects of market structure, the Commission will frustrate its ability to undertake a more constructive comprehensive review of market structure. I am concerned that considering particular features of dark pools in isolation increases the risk of unintended adverse consequences and will not yield the best results for our markets. The release acknowledges that, in the relatively near term, the Commission is expected to consider a concept release covering numerous aspects of market structure. As an initial step in considering reforms that may be warranted, perhaps the dark pool issues before the Commission today should be deferred and instead addressed in the concept release.
Against the backdrop of this general reservation, I am especially interested in hearing from commenters on the following.
- Is the current level of non-displayed liquidity and market fragmentation represented by dark pools compromising the quality of the displayed market? Non-displayed liquidity is not new, although the extent and nature of it has evolved. And while market fragmentation has long been a regulatory concern, it is important to consider that the advancement of different trading venues is a key source of competition that can benefit investors.
- What is the most likely market impact of treating actionable IOIs as quotes and lowering the Regulation ATS public display threshold from 5% to 0.25% of trading volume for a particular stock? Will these proposals result in an appreciable increase in displayed liquidity? Or will dark pools simply become “darker” (i.e., choose not to send actionable IOIs) with the current volume of dark pool activity largely persisting?
Trading activity will change in response to the proposals if they are adopted. The release emphasizes the prospect that the proposals will result in more displayed quotes. To some extent, more quotes likely will be displayed. But more public quotes may not be the predominant result of the rule amendments. Rather, as market participants adjust to new public display obligations, the information contained in IOIs might be scaled back so that IOIs, as a matter of practice, are non-actionable and thus are not quotes that must be publicly displayed. Presumably, if IOIs signal less information, those looking to interact with non-displayed liquidity would rely more on “pinging” or other techniques to test liquidity across dark pools. If this scenario occurs instead of there being a meaningful increase in displayed liquidity, it is worth asking whether the rule amendments before us ultimately would be beneficial. In other words, might the status quo be preferable to darker dark pools?
- At what point does an ATS’s public display obligation render dark pools — or at least certain models of dark pools — unviable? If what constitutes an actionable IOI proves to be particularly expansive, how would a 0.25% volume threshold for public quoting impact the functioning of dark pools? Even if what constitutes an actionable IOI is relatively narrowly construed, the drop from the current 5% volume threshold to 0.25% is a major change.
- The demand for non-displayed liquidity presumably will continue, despite any regulatory changes that may be adopted. If the regulatory regime significantly impinges dark pools, what type of trading activity might replace current dark pool trading? Where might current non-displayed trading interest go? To foreign markets? As I already suggested, it may not be correct to presume that it becomes displayed.
- The release appropriately recognizes the importance of allowing certain large orders to be dark to avoid “information leakage” that could disadvantage an investor behind the order. Each rule amendment contains an exclusion for an order worth $200,000 or more. Should the large order exclusion not only cover an order worth $200,000 or more but also cover an order of a certain number of shares? A “block size” under Rule 600(b)(9) of Regulation NMS, for example, includes an order with a market value of at least $200,000 or of 10,000 or more shares. This 10,000-share threshold is not part of the Commission’s rule proposal today. Further, should the large order exclusion accommodate the practice of breaking up large orders into smaller orders that are executed separately?
- What informational signals might be sent if the actual dark pool where a trade was executed is disclosed publicly? What, if anything, might such post-trade transparency signal about who is trading in a particular venue, their trading interest, and their trading strategy? How might any such information leakage impact trading and our markets? Would periodic public disclosure of the trading volume of individual dark pools strike a more appropriate balance given the interests at stake, provided that the disclosures are standardized across dark pools?
As the Commission considers this rulemaking going forward, it is important to recognize that our markets operate more efficiently and effectively because of innovation and competition. Investors benefit when the regulatory regime affords trading venues — whether they are exchanges or ATSs — room to offer an evolving array of products, services, and trading opportunities that serve the diverse interests of investors.
I look forward to considering the comments we receive.
In concluding, I join my colleagues in thanking the staff — particularly those from the Division of Trading and Markets and the Office of Economic Analysis — for their hard work.