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Regulators Take Aim at Dark Pools

As the SEC looks to improve market transparency, dark pools have come under renewed fire. Three regulatory proposals have raised buy-side opposition.

Can't Put a Price on Blocks

Amid concerns about the SEC's three proposals, perhaps the area that troubles traders and dark pool operators the most is the expression of the block-size exemption in a dollar threshold. According to Pipeline's Federspiel, while the majority of Pipeline's trades would be covered by the $200,000 large-size exemption, the dollar threshold does not effectively address trading of blocks in small-cap or micro-cap securities.

If the proposed regulations were put in place as is, Pipeline would have to "restrict the way our system is used for micro-cap securities, so we're working to keep that from happening," Federspiel notes. "We intend to continue to work with the regulators on refining that block definition and work toward an exemption that would enable us to deliver the same size discovery innovations to micro-cap funds."

Instead of a dollar threshold, Federspiel offers, the threshold should be based on the typical liquidity of a stock. "The intention of the regulators is to gather together the best bids and offers on all of the small orders that contribute to the price discovery process, and they want those orders to be publicly displayed as much as possible," he explains. "They recognize that orders that are significantly larger than those that can be executed in public markets deserve a special home and are too large to take part in the price discovery process, as it would lead to unacceptable trading losses."

ICM's Olsen also says a dollar threshold is inadequate. "The rules need to make sure they accommodate the smaller-cap names -- that's why these dark pools were created," he comments. "It's amazing how much the buy side opens up to a dark pool versus another human being on the phone and shows them their whole blotter if its buy side-to-buy side."

Establishing a block exemption in terms of share size would be "much easier" than a dollar threshold, contends Tim Mahoney, CEO of BIDS Trading, operator of the BIDS ATS. "It's hard to change everything into dollar amounts. If a stock is vacillating between $199,000 and $201,000, is it a block? You know for certain the size of a trade; but calculation of the dollar value is additional to the process," he relates.

"It would be more appealing to use a volume point that would reflect market cap," notes TABB's Berke. "They should take into account market cap or trading volume in the stock so that illiquid, difficult-to-trade names are not taken out of these dark pools -- that's why traders go to dark pools, to trade the tough stuff."

IOI Confusion

Another major source of debate amid the SEC's proposals is the proposed treatment of actionable indications of interest as quotes. While the SEC estimates that 11 of the 29 active dark pools in NMS stocks use some form of IOI, there is still a lot of confusion in this area, and it's difficult to pinpoint which pools leverage IOIs.

"There are dark pool providers who are completely dark and do not communicate any order information with any other dark venues, and clients have the choice of going to those dark pools for that reason," relates TABB Group's Berke. On the other hand, there are dark pools that offer the ability to "give a little to get a little," Berke adds, comparing their operating model to the old "upstairs" trading room. "With proper transparency about how that communication takes place between dark pools," Berke says, "traders will say there are circumstances when they might choose to use an IOI on a certain order and of course circumstances where they would not."

In fact, according to TABB Group's annual study, "Institutional Equity Trading 2009-2010: Dark Pools, Transparency and Consequences," 71 percent of buy-side traders acknowledged that they are aware that the dark pools they use sometimes send IOIs to other dark pools (see chart, page 14). Of that 71 percent, 50 percent said they avoid dark pools that use IOIs, while 47 percent said they consider them with certain orders.

"The head trader is saying, 'We're big boys and girls, ... and we're capable of making decisions on the best places to trade,' " according to Berke. "Sometimes ... traders don't use IOIs. But obviously there are cases where it does fit, and it's a tool that a trader might decide to use with certain orders."

If the SEC eliminates or restricts the use of IOIs, some of the less-liquid, lower-volume dark pools could have a tough time surviving, Berke contends. "If there's not linkage between some of the smaller dark pools and some of the bigger pools, then the smaller ones might not be able to go it alone, and there might be consolidation," she predicts, adding that consolidation of dark venues could in turn result in greater consolidation of order flow.

Still, "The SEC has always been concerned with unbalanced information exchange and two-tiered markets that give certain participants an informational advantage over others," notes BIDS Trading's Mahoney. "It was well understood that they were going to come out with something on actionable IOIs or something closely related to the ban on flash orders," he points out.

"If people are utilizing these types of facilities within dark pools, then they should have to be transparent about it," argues Barclays Capital's Fagen. "IOIs have a very significant place in the high-touch business and always have; they are also utilized in the low-touch business around operations between different liquidity pools. But there definitely needs to be some clean up and clarification around them."

The smart order routers used by many dark pools to route IOIs may be a particular source of confusion, as they are not explicitly covered in the SEC's proposal. "There are IOIs coming out of smart order routers, but the question is, are the regulators looking at just IOIs out of ATS' or IOIs out of smart order routers, too?" asks Jonathan Kellner, president of Instinet, operator of the Instinet CBX and Instinet Crossing dark pools. "There's a lot of confusion there."

One executive from a large broker-dealer who requested anonymity concedes that he's looking for a clear definition of what constitutes an IOI originating from an ATS. "The commission is a bit vague on what is going to become a quote," he says. "We also feel that a number of our competitors' claims that they never send out IOIs out of their ATSs -- nobody claims it's them -- I think a few of them are being a bit disingenuous by claiming to never send IOIs out of their pool. But they will concede that they send out IOIs out of their router. Either you do or you don't."

The broker-dealer executive also acknowledges that the broker-dealer IOI threshold could be problematic. "The proposed lower thresholds apply to ATSs only and not to broker-dealers, who have their own, higher threshold," he says. "It becomes confusing when there are broker-dealers with wholesale business that use IOIs and don't fall under the ATS definition."

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