Pool Rules

Last October, when the US Securities and Exchange Commission (SEC) first released its proposals for dark pool regulation, officials including chairwoman Mary Schapiro and trading and markets division co-acting director James Brigagliano characterized the effort as part of the regulator’s broader focus on improving equity market structure. They cited prevention of two-tiered market access, promotion of displayed liquidity and better transparency of trade data as key drivers behind the proposals.

Three key areas make up the SEC’s regulatory proposal, providing some specifics as to what might ultimately become law:

• Actionable indications of interest (IOIs) in unlit venues would have to be treated and disclosed the same way as other buy and sell quotes.

• For all alternative trading systems (ATSes), including dark pools, trading volume thresholds for displaying best-price orders would fall from 5 percent of a stock’s trading volume to .25 percent.

• Dark pools executing trades would have to disclose their identities in real time in order to create post-trade transparency akin to that of registered exchanges.

Although exactly what final shape these rules assume has yet to appear, dark pool providers and participants can now make at least educated guesses as to what eventual compliance will require. But as the dark pool arena has developed into a heterogeneous state, the SEC proposals would not apply evenly across the market. Infrastructure and compliance work required by a dark pool specializing in block trading, for example, would differ substantially from what a venue operating more as an internalization engine would have to undertake, thanks to provisions in the proposals exempting block-sized trades totaling more than $200,000. And some elements of the SEC proposals—especially the real-time disclosure rule—could challenge the very value proposition dark pools provide for buy-side and hedge fund traders. In short, the proposals are not without challenges, but those challenges will vary across different elements of the dark pool universe.

The SEC’s proposals could also ultimately affect markets beyond its US jurisdiction: European dark pool markets have attracted their own degree of regulatory scrutiny, and EU and UK Financial Services Authority (FSA) rulemakers have shown greater inclination of late in coordinating their regulatory efforts with those across the pond. As European regulators take note of the SEC’s dark pool approach, so too should European asset managers.

Real-time Reservations

Of most immediate concern to dark pool providers and their clients is the SEC’s proposal to require real-time post-trade disclosures. Industry sources fear such a rule would make it more difficult for some venues to prevent information leakage, and ultimately thwart traders’ efforts to reduce market impact; sources do not expect the requirement to make it into the final draft of any dark pool regulation.

“Obviously most of the venues are against this, and rightfully so,” argues Cheyenne Morgan, an analyst at Tabb Group who follows dark pool trading issues. “I think that requirement would end up providing too much information that could be taken advantage of by players looking to game the dark pools. By giving out that information in real time, I’m not sure exactly what benefit that would provide.”

Beyond the potential for information leakage, real-time identity disclosure could threaten some venue providers’ very business models, Morgan adds.

“Really, we are talking about the whole point of dark pool trading—so that you can trade without having any market impact,” Morgan says. “To attach a name to where a stock is trading in terms of dark pools defeats the whole purpose, and I don’t think dark pool operators will be very receptive to that proposal.”

Sources at alternative liquidity providers ITG and Liquidnet have pushed for more of a delayed disclosure process to both improve post-trade transparency and keep in place market impact protections that draw traders to dark pools in the first place.

“In its concept release the SEC has said it wants to look at the whole market structure and not just make piecemeal changes, and I don’t see the real-time ATS reporting requirements as something that will ultimately be adopted,” says Howard Meyerson, general counsel at Liquidnet. “I think it will be more of a delayed arrangement.”

Mark Wright, global head of product management at ITG, agrees that real-time attribution requirements would present problems, but warns against aiming for too long of a delay.

“A lot of people were, in our opinion, trying to water this rule down and go to end-of-day or end-of-week total shares reporting, but we think there is a lot of value in providing full transparency so that people doing analysis can understand how dark pools are working, the relative quality of their executions and so forth,” says Wright, adding that delays to protect venue participants are fine so long as that transparency is still provided.

“Don’t take away all this rich data that does exist in displayed markets—why wouldn’t you have that available so people can also assess how dark pools work?”

End-user Effects

Buy-side and hedge fund traders incorporating dark pools into their trading strategies would not likely face as direct an effect as venue operators in terms of technology or processes, but that doesn’t mean business as usual for these firms.

Since the advent of alternative electronic liquidity sources, dark pools have become critical components of many buy-side and hedge fund managers’ trading strategies as their traditional equity markets have fragmented and information leakage prevention has become more crucial. How acutely an individual manager would feel the impact of pending regulatory action depends in large part on the firm’s trading and investment strategies, as well as which types of dark liquidity it typically sources.

Kevin Chapman, managing director and trader at Allianz Global Investors Capital in San Diego, says he anticipates little effect of SEC regulation on how his firm uses dark pools, but emphasizes that managers more reliant on shorter-term and high-frequency strategies may face more of a challenge.

“Dark pools fit in just like any other venues in our quest for liquidity—we go to dark pools as we would anyplace else,” Chapman says, adding that his firm’s typical investment duration is at least nine months.

“But I think this is definitely a big challenge for the people running these pools and on the technology side of things, and this is also probably a big deal for the latency arbitrage traders, the high-frequency traders and shorter-term duration investments—people who look for and try to gain liquidity,” he says. “But for us, if the SEC does change the way you have to report a trade or the way it is quoted, it won’t matter too much because if we find that a particular pool isn’t successful for us, we will just go somewhere else.”

Chapman does see the potential for increased trading costs if regulation makes it more difficult or expensive for dark pool operators to do business, as well as the likelihood that some investment strategies could disappear outright, but only a minor impact on long-only institutions.

“For other people and other styles of trading, if their duration is extremely short this regulation will impact them greatly,” he says. “Certain strategies like latency arbitrage could disappear—it really depends on what you are  trying to do. For us, it really doesn’t matter if it all ends up going back to one exchange, so it is less important.”

Pre- vs. Post-trade Attention

If some asset managers have little to fear from dark pool regulation in terms of a direct impact on their trading and infrastructure, they should nonetheless bear in mind the potential lost liquidity sourcing opportunities that could result from new rules restricting some venue providers’ activities.

Paul Squires, head of trading and deputy head of trading and securities financing at London-based AXA Investment Managers, says the SEC as well as European regulators who may follow the SEC’s lead should regulate surgically rather than in broad strokes.

“We are keen on retaining access to dark pools and while we can see the case for regulation of some aspects of dark liquidity, it really, really needs to be done discriminately,” Squires says, adding that in his view, post-trade consolidation issues warrant more attention from regulators than pre-trade transparency when it comes to dark liquidity.

“We see a stronger regulatory case for post-trade issues—in other words, to have some kind of consolidated rules on reporting requirements so that there’s more visibility. I know it is a broken record from my peer group about the whole post-trade consolidation issue.”

An overly cumbersome new regulatory regime could also stifle important liquidity sources for some managers, Squires says, particularly when it comes to brokers providing buy-side access to their internal order flows.

“In terms of some brokers offering access to their internal flow, which makes for a kind of dark pool, we also want to some extent protect their capacity to give us that service,” he says. “If it is overregulated to the extent that those brokers are no longer capable of giving us that service, that would be a detrimental step for us.”

Influence Beyond the US

As prospects for dark pool regulation in the US unfold, UK and European markets have hardly taken a wait-and-see approach. Although unlit liquidity venues in Europe remain relatively immature, industry participants anticipate their regulators will be taking significant cues from how the SEC deals with the issue.

“You can’t escape the fact that the regulators are trying to some extent to coordinate their focus, whether you are talking about dark pools or flash orders or anything else,” says Squires at AXA.

“So while you can talk about the independence of the regulators, we all know that if the SEC is doing something then the FSA and other regulators will be paying attention and we need to be aware of it—chances are that what they are doing will come into play at some level here.”

Squires adds that dark pool providers and participants can surmise how European dark pool developments will play out based on events in the US.

According to Lee Hodgkinson, CEO at London-based multilateral trading facility (MTF) SmartPool, the ultimate goal of both US and European regulators is improved market transparency. How European regulators handle dark pools will as such come into play as part of a larger effort to boost transparency, Hodgkinson says.

“Of course, Europe has a different regulatory framework, but at the headline level we are talking about the same kind of regulatory effect,” he says, but notes that European markets lack a trade-through rule and a consolidated tape, which will result in a somewhat different debate there.

“Broker-dealer dark pools, which, contrary to popular belief, are regulated through their banking activity, are not MTFs and so they don’t have to publish in such granular detail information, and they don’t have to publish information in the same timeframe as MTFs such as SmartPool,” Hodgkinson explains. “There are legitimate reasons why—a lot of the time they are committing capital and taking on risk. But a broad theme of change in Europe will be improved post-trade transparency for dark trading and over-the-counter (OTC) trading. So it is much bigger than just dark pools.”