The Financial Industry Regulatory Authority (FINRA) filed a rule
proposal with the Securities and Exchange Commission (SEC or the
Commission) on September 30 that would impose reporting
requirements on alternative trading systems (ATSs), including dark
pools.[1] Dark pools are a type of ATS in which
participants can transact their trades without displaying
quotations to the public.[2] Pursuant to the proposed
rules, each ATS must report its aggregate weekly volumes and number
of trades on a security-by-security basis to FINRA and indicate
which trades take place on ATS platforms. Although the proposed
rules will not apply to off-exchange trading venues that are
excluded from Regulation ATS requirements,[3] the rules,
if approved by the SEC, will increase publicly available
information about these opaque and rapidly growing private
markets.
Alternative trading systems are threatening to supplant traditional
exchanges. In a speech at the Security Traders Association's
market structure conference on October 2, SEC Chair Mary Jo White
stated that more than half of the orders of long-term investors are
executed on off-exchange "dark" venues.[4]
However, only limited data on ATSs is publicly available.
Commercial sources, including Rosenblatt Securities and Tabb Group,
provide subscription sources of information on ATS trading, but
these sources rely on self-reported data, which is limited in
scope.
Dark pools match up trades of buyers and sellers anonymously,
thereby allowing investors to trade large blocks of securities
without having news of their orders move the market. While
historically dark pools were used by large institutional investors,
the average trade size has been declining as hedge funds and
high-frequency trading firms have started to migrate to these
systems.
Dark pools have been on FINRA's radar since at least last fall,
when the regulator issued examination letters to several operators
of ATSs, seeking copies of policies and procedures, descriptions of
the visibility of order information by clients, information about
how each firm uses indications of interest, and data on error
handling and complaints, among other information. Earlier this
year, FINRA sent a second round of letters, seeking information on
how ATSs operate, how they route orders, what they disclose to
clients and how they police trades.
FINRA is proposing to adopt new FINRA Rule 4552, which will require
each ATS to report volume information regarding transactions within
the ATS in securities (both equity and debt), subject to FINRA
reporting obligations. Each ATS will be required to report to FINRA
the aggregate weekly volume of transactions and number of trades
within the ATS by security, within seven business days after the
end of each calendar week. FINRA proposes to post the reported
information on its website regarding National Market System (NMS)
stocks in the S&P 500 Index or the Russell 1000 Index and
certain exchange-traded products on a two-week delayed basis. All
other NMS stocks and over-the-counter equity securities subject to
FINRA trade reporting requirements would be published on a
four-week delayed basis, to minimize potential market impact.
In a webcast to FINRA members, Richard Ketchum, FINRA's chief
executive, stated that the rules will enable FINRA to understand
the amount of activity occurring in each ATS, thereby increasing
information about ATS trading generally and dark pool trading in
particular.[5]
The proposed rules will also require each ATS to use a unique
market participant identifier (MPID) when reporting order or trade
information to FINRA. Under current FINRA rules, although each
over-the-counter securities transaction in which an ATS is involved
must be reported under FINRA rules, a broker-dealer operating an
ATS may report trades executed within the ATS using the same MPID
it uses for transactions in other areas of its business, making it
impossible to determine from the trade reporting data which trades
were executed on the ATS as opposed to other areas of the
broker-dealer's business. Use of a unique MPID will permit
FINRA to closely monitor for abusive conduct the trading that
occurs in each ATS. Ketchum described the effort as "a real
positive step from a market-integrity
standpoint."[6]
Not surprisingly, the stock exchanges have requested that
regulators curb trading in dark pools. Earlier this year, the chief
executive officers of NYSE Euronext Inc., Nasdaq OMX Group Inc. and
BATS Global Markets Inc. asked the SEC to pass a rule requiring
brokers to route an order to an exchange unless they can improve on
the best public quote by a defined amount.
FINRA is not alone in seeking more information about dark pool
trading. As early as 2009, the SEC voted to propose measures
"intended to increase transparency of dark pools so investors
can get a clearer view of stock prices and
liquidity."[7] In testimony before the Senate
Banking Committee in March 2013, Mary Jo White noted that dark
pools, among other technological developments, raise many
questions, stating, "Do they result in unnecessary volatility,
or create an uneven playing field? Or do these modern-day features
bring benefits such as efficiency, price reduction, and healthy
competition to our markets? Do they do all of these things? The
experts and studies to date have not been consistent or definitive
in their observations and findings about whether and to what extent
harm is caused by the current market structure and
practices."[8]
The SEC is seeking to answer these questions, and others, through
more sophisticated data analysis. On October 9, the SEC announced
that it was making a vast trove of data drawn from MIDAS, the
SEC's market information and data analysis service, available
on its website, to help inform the broader market structure
debate.[9] The resources include a paper providing key
metrics describing the underlying nature of off-exchange trading by
the ATSs that trade equity securities, and a paper summarizing
current studies addressing visible and dark market
fragmentation.
By proposing rules requiring ATSs to report aggregate volume
information and number of trades on a security-by-security basis
and to obtain a unique MPID designed for exclusive use for
reporting each ATS's transactions, FINRA is taking the first
step toward increasing transparency in dark pools. We will continue
to monitor this evolving area of regulation.
----------
[1] Regulation ATS defines an alternative trading system as
"any organization, association, person, group of persons, or
system: (1) That constitutes, maintains, or provides a market place
or facilities for bringing together purchasers and sellers of
securities or for otherwise performing with respect to securities
the functions commonly performed by a stock exchange within the
meaning of [Exchange Act Rule 3b-16]; and (2) That does not: (i)
Set rules governing the conduct of subscribers other than the
conduct of such subscribers' trading on such organization,
association, person, group of persons, or system; or (ii)
Discipline subscribers other than by exclusion from trading."
17 C.F.R. § 242.300(a). Although ATSs operate similar to
traditional exchanges, they are regulated as broker-dealers rather
than as national security exchanges. The proposed rule change
applies to any alternative trading system, as that term is defined
in Regulation ATS, that has filed a Form ATS with the
Commission.
[2] Securities and Exchange Commission Press Release, SEC Issues
Proposals to Shed Greater Light on Dark Pools, Oct. 21, 2009,
available at http://www.sec.gov/news/press/2009/2009-223.htm
(SEC Dark Pool Press Release).
[3] Regulation of Exchanges and Alternative Trading Systems, Final
Rule, SEC Release No. 34-40760, 63 Fed. Reg. 70844 (Dec. 22,
1998).
[4] Mary Jo White, Chair, U.S. Securities and Exchange Commission,
Address to Security Traders Association 80th Annual Market
Structure Conference, Focusing on Fundamentals: The Path to Address
Equity Market Structure (Oct. 2, 2013), available at http://www.sec.gov/News/Speech/Detail/Speech/1370539857459
(Mary Jo White STA Speech).
[5] FINRA, July 2013 Board Update, available at http://www.finra.org/Industry/Regulation/Guidance/.
[6] Id.
[7] SEC Dark Pool Press Release.
[8] Testimony of Mary Jo White, Nominee for Chair of the U.S.
Securities and Exchange Commission Before the United States Senate
Committee on Banking, Housing and Urban Affairs, Mar. 12, 2013,
available at
http://www.banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=619e5603-c2c8-4085-98c6-0014ce29bde7.
[9] Mary Jo White STA speech.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
