As 2010 approaches the closing bell, all eyes on Wall Street are fixed on the Securities and Exchange Commission as the regulator deliberates a range of market structure issues, headlined by the Flash Crash, high-frequency trading and dark pools. But, with so much on its plate, what is the agency likely to accomplish in the remaining weeks of 2010 -- if anything -- and which issues on its agenda will be pushed out to 2011?
Because the SEC is responsible for writing 100-plus rules for the Dodd-Frank Wall Street Reform Act, and because it also continues to deal with fallout from the Flash Crash, industry participants on both the buy and sell sides agree, it's unlikely to act this year on the slew of rules it proposed back in January to revamp the U.S. stock market. "I don't think you get much [done] this year," says Tim Mahoney, CEO of BIDS Trading, an alternative trading system for institutional-size orders.
"In the same way the Flash Crash became a huge distraction from the naked-access ban, Frank-Dodd is really slowing down a lot of other considerations at the SEC," agrees Jeffrey Wecker, former president and CEO of Lime Brokerage. "It's hard to know how much the swaps/ derivatives focus of Dodd-Frank is taking away their attention from completing other parts of their agenda," he adds, noting that the agency already has spent five months working with the Commodity Futures Trading Commission on a final report to determine the causes of the May 6 market meltdown (see related article, page 11).
Heading into next year, BIDS' Mahoney predicts, the SEC will take a "broader view" of market structure. "You'll see a much more holistic approach from the SEC next year on many of the issues," he says. Mahoney expects the SEC to come out with a new concept release in 2011 seeking industry comments.
The regulator, however, has yet to act on a concept release published Jan. 20, 2010, seeking public comment on a broad range of issues, including high-frequency trading, colocation of trading terminals and markets that do not publicly display price quotations (i.e., dark pools). In examining the market structure, the SEC is questioning whether the current, highly automated, high-speed environment is fundamentally fair for investors.
Among other issues, it is wrestling with whether to impose market maker obligations on high-frequency trading firms, and whether colocation provides an unfair advantage to proprietary trading firms that are able to place their servers in data centers side-by-side with exchange matching engines. It also is examining the thresholds for Regulation ATS, considering lowering the percentage of volume at which dark pools need to display quotations in specific stocks.
But while its actions surely have been delayed, the SEC, which also is working on regulations for over-the-counter derivatives, may yet accomplish more in terms of equity market structure before the year ends. The commission said in late October it plans to ban naked sponsored access on exchanges and alternative trading systems, indicating that it would act when it meets on Nov. 3. (Ed. note: At press time, the SEC had not decided whether it would require brokers to put in place pre-trade risk controls to monitor their customers that have direct market access to exchanges and ATSs.) And, according to published reports, the SEC is pressuring the exchanges to devise a limit-up, limit-down proposal before the end of the year to address sudden price moves.
Shedding Light on Dark Pools
Behind high-frequency trading, perhaps the most controversial market structure issue the SEC has been examining is the proliferation of dark pools, private venues that match institutional orders without displaying a quote to the market. There is ongoing concern from buy-side traders that dark pools, as they continue to increase their volume, will detract from the price discovery process on the primary displayed markets. According to the SEC's January 2010 concept release, as of September 2009, there were approximately 32 dark pools, which controlled 7.9 percent of overall volume, while internalization of orders within 200 brokerage firms accounted for 17.5 percent of volume -- meaning that about 25 percent of the market's total volume is executed off-exchange in non-displayed trading centers.
"The SEC is struggling with the unintended consequences of a disincentive to display liquidity," comments Cheevers & Co.'s McDevitt, whose firm uses dark pools as part of its execution process. "But if the SEC acts to limit the influence of dark pools, they better be careful about the unintended consequences."
Though trading in dark pools is anonymous in order to protect the institutions that are trading large orders against market impact, all the trades are printed to the tape -- but without identifying the specific dark pool. Many buy-side traders, however, argue that there is a lack of information about dark executions, particularly for the investing public.
In the January 2010 market structure concept release, the SEC asked the industry to comment on real-time reporting of dark pool trades and proposed disclosing the identity of the dark pool that executed the trade. "It's clear that non-displayed liquidity is very high on the SEC's priority list," says Khandros of Liquidnet, which operates the only buy-side-only dark pool for institutions and counts 600 of the largest asset managers as customers.
"We obviously worked with dozens of members on these issues. The members do not want real-time identification of trades," he insists. "They want the trade to be identified at the end of the day after the market has closed. Any additional information they have to give up is information leakage and market impact costs."
Khandros also suggests that dark pools pose less of a threat to the exchanges than is being portrayed. He acknowledges that approximately 30 percent of U.S. equity volume is traded off-exchange (dark pool volume plus volume internalized within broker-dealers). But, "That proportion hasn't changed in decades," he says, insisting that dark pools have not gained market share at the expense of the exchanges. Rather, "What used to be traded in the upstairs market on the phone," he explains, "is being handled by an ATS and through algorithms."
In addition, dark pool operators, including Liquidnet and BIDS Trading, insist they are helping institutional investors execute large-size blocks in a fragmented market, and each contends that the SEC should differentiate in its rulemaking between dark pools that execute large orders versus those that focus on small orders. "Most off-exchange venues have execution sizes of 300 shares or less, whereas at Liquidnet, close to 50,000 shares is our average execution size, so we're a wholesale execution model," Khandros stresses. Also, he contends, Liquidnet provides 100 percent price improvement, which is the midpoint between the bid and ask. "The SEC seems to be focusing on the off-exchange systems that give very little price improvement," he says.
Ultimately, "You'll see more transparency in the dark pools," says ConvergEx's Cangemi, but they won't evaporate any time soon. "Dark pools will exist -- they are a competitive part of the market structure. Dark flow is a prerequisite to any trading model. It's like poker -- not all your cards can be on the table," Cangemi asserts.
Further, the SEC's Flash Crash report showed that dark pools didn't play a role in the turmoil on May 6, so there's a possibility that the commission will see the dark pool concerns as less urgent. "As the SEC looks at the dark pool proposal, it probably seemed important how dark pools reported their volume," BIDS' Mahoney says. "But after May 6, there are more fundamental issues. Whether we report single-counted or double, whether it's end-of-day or live, it's probably not a driver" of the SEC's agenda.
Besides, Mahoney adds, regulating dark pools is complicated. For example, "When you start diving down into dark pools," he says, "there are IOIs from one dark pool to another."
- Page 2: Setting Priorities
- Page 3: Naked Access: 'A Ticking Time Bomb'
- Page 4: Shedding Light on Dark Pools
- Page 5: IOIs and Flash Orders: A Two-Tiered Market?