Strengthening the Regulation of Dark Pools
SEC Open Meeting
October 21, 2009
The Securities and Exchange Commission voted to issue proposals designed to shed greater light on “dark pools” of liquidity. Dark pools of liquidity are a type of alternative trading system (ATS) that does not display quotations to the public.
The number of active dark pools transacting in stocks that trade on major U.S. stock markets has increased from approximately 10 in 2002 to approximately 29 in 2009. For the second quarter of 2009, the combined trading volume of dark pools was approximately 7.2% of the total share volume in these stocks, with no individual dark pool executing more than 1.3%.
Given the growth of dark pools, this lack of transparency could create a two-tiered market that deprives the public of information about stock prices and liquidity.
To make trading through dark pools more transparent, the proposals would:
- Require generally that information about an investor’s interest in buying or selling a stock be made publicly available, instead of just to a select group operating with a dark pool.
- Require that dark pools publicly identify that it was their pool that executed the trade.
The dark pool proposals are intended to enhance transparency and promote fairer, more efficient markets for U.S.-listed stocks.
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. But that so-called indication of interest (IOI) is communicated only to a subset of market participants.
That means that investors operating with the dark pool have access to information about a potential trade that other investors using public quotations do not. As a result, dark pool participants are able to have their orders filled, while those on publicly displayed markets go unfilled, even though dark pools use the information from publicly displayed markets to price the dark pool transactions. When dark pools share information about their trading interest with other dark pools, they can function like private networks that exclude the public investor.
What Specific Concerns About Dark Pools Is the Commission Seeking to Address?
In most cases, before a trade is executed, a quotation is publicly displayed for other investors to see. But, with dark pools, a participant’s IOI is only conveyed 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 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.
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. 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 Proposals Address These Concerns?
The Commission voted to propose rules designed to address the pre-trade disparities stemming from the use of actionable IOIs by dark pools and other trading venues, including OTC market makers.
The first proposal would ensure that actionable IOIs are treated like quotations and are subjected to the same disclosure rules as those that apply to quotations.
The second proposal would lower the ATS trading 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. This proposal would lower that percentage to 0.25%, including for dark pools that use actionable IOIs.
Taken together these changes would help make the information conveyed by actionable IOIs available to the public instead of just to a select group operating with dark pools.
At the same time, both proposals would exclude from their requirements certain narrowly targeted IOIs related to large orders. These size discovery mechanisms are offered by dark pools that specialize in large trades. In particular, the proposal would exclude IOIs for $200,000 or more that are communicated only to those who are reasonably believed to represent current contra-side trading interest of equally large size. The ability to have a method for connecting investors desiring to trade shares in large blocks can enable those investors to trade efficiently in sizes much larger than the average size of trades in the public markets.
The Commission also voted to issue a proposal that would create a similar level of post-trade transparency for ATSs as for registered exchanges. Specifically, the proposal would amend existing rules to require real-time disclosure of the identity of dark pools and other ATSs on the public reports of their executed trades.
This proposal would exclude the ATS reports of all large trades of $200,000 or more 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 these investors.
The Commission will seek public comment and data on certain issues relating to dark pools. However, dark liquidity in all of its forms raises a variety of important policy issues that deserve serious consideration. These overarching issues are part of the Commission’s broad review of equity market structure that is ongoing. This review will encompass the benefits and drawbacks of dark liquidity in all its forms.