Why Did The SEC Never Approve Their 2009 Proposal For Regulation Of Dark Pools?


While we and others have tried over the past few years to shine a brighter light on dark pools, it has been a relatively futile process.  However, with last week’s New York Attorney General charges against Barclays dark pool, a bright spotlight is now beaming down upon the forty or so dark pools. While the Barclays suit was extremely damning, it dealt mainly with how Barclays was allegedly fraudulently marketing the banks dark pool to their own clients.  We think that, while the AG’s suit will probably be very damaging for Barclays, it still does not dig far enough.  We think that regulators have a prime opportunity to act right now.

You will most likely recall from some of our prior notes that the SEC already proposed regulation of dark pools back in November 2009 ​ . There were three key components of this proposal:

1- First, the SEC proposed amending the definition of “bid” or “offer” to apply expressly to actionable indications of interest (“IOIs”) privately transmitted by dark pools and other trading venues to selected market participants.  ​

2- Second, the SEC proposed lowering of the trading volume threshold in Regulation ATS that triggers public display obligations for ATSs from 5% to 0.25%.

3- Third, the SEC proposed requiring real-time disclosure of the identity of dark pools and other ATSs on the reports of their executed trades.  ​ ​

After numerous industry participants commented on the SEC proposal, the SEC chose to do nothing and never approved the rule.  Comments were due in February 2010.  We thought it would be interesting to go back and read these comment letters again to try and figure out why the SEC punted.  Here are just a few highlights of what industry participants said about dark pool regulation:

Credit Suisse:  Credit Suisse supports the proposal to reduce this threshold to .25%, and urges the Commission to eliminate this threshold entirely. Credit Suisse strongly opposes the proposed real-time post-trade disclosure of the identity of ATSs. Credit Suisse also agrees with the Commission that actionable lOIs disseminated to others by ATSs should rightly be viewed as firm orders that should be published to all market participants.”

Goldman Sachs:  “We generally support the Proposal, and encourage the Commission to continue to provide interpretive guidance as market practices evolve and give rise to new types of orders and order placement mechanisms that may fall within the context and spirit of these new rules.”

GETCO: “In our view, actionable lOIs are not dissimilar to flash order types, which we have opposed in previous comment letters — both are basically quotes privately disseminated to a select or limited group of market participants and both convey valuable information about available liquidity.  ​

Sharing quote information among dark pools has the potential to create a private network that excludes public investors. ..Given the concerns cited in the Release, GETCO believes reducing the volume threshold for display from 5% to 0.25% seems reasonable. “

Overall, it seemed that most industry comment letters supported two of the three SEC recommendations: treating IOI’s as orders and lowering the quote threshold to 0.25%.  When it came to post trade transparency, most industry comment letters were against it.

Why were industry participants who owned their own dark pools in favor of two of the three recommendations by the SEC?  We would have thought they would be against the new rules.  If you dig a little further, like Morgan Stanley did, you’ll find the answer.  Here is what Morgan Stanley said in their comment letter:

We believe that many of these issues, including the Proposal, are symptoms of the larger underlying cause – aggressive order handling/routing practices that have emerged in recent years. These practices, including the aggressive use of actionable lOIs and blind pinging, are driven by economic incentives to engage in such practices across many different venues and market participants, not just by dark pools. The economic incentives that exist in the market to reduce execution costs inevitably lead to a race for cheaper execution alternatives. The acceptance of the “free look for a free execution” mantra has lead to many market participants, including broker-dealers and exchanges, routing their orders to various alternative liquidity providers in lieu of the traditional lit marketplace. Competition and advances in technology have not only permitted, but have encouraged participants to look for the most cost effective ​execution, many times in conflict with the underlying customer whose order information is being “leaked” to sophisticated market participants and who is not the ultimate recipient of the resulting economic benefit.

Morgan Stanley’s comment letter found a major loophole in the SEC proposal on limiting IOI’s in dark pools: “The SEC’s Proposal would not cover these types of arrangements and such a gap in regulation could lead others who transmit IOIs from their dark pools to establish similar infrastructure changes to avoid regulation.”

Was it possible that the SEC never approved the rule because they realized that the IOI component of their rule needed to be stronger and reach deeper into the routing of orders?  Either way, something should have been done back in 2010 and something needs to be done now.  We recommend that the SEC dust off their 2009 dark pool regulatory proposal and address Morgan Stanley’s concerns about the real root cause of the problems – the economic incentives of order routing.