Why Did It Take The SEC So Long To Discover The UBS Dark Pool Violations?
The Securities and Exchange Commission (“Commission”) deems it appropriate and in the public interest that public administrative and cease-and-desist proceedings be, and hereby are, instituted pursuant to Section 8A of the Securities Act of 1933 (“Securities Act”) and Sections 15(b) and 21C of the Securities Exchange Act of 1934 (“Exchange Act”) against UBS Securities LLC (“UBS”).
Summary of SEC Findings
Yesterday the SEC accepted a settlement offer from UBS in excess of $14 million, where UBS neither admitted nor denied the findings, resulting from how UBS ran its dark pools. Specifically:
1) Prior to 2010 UBS did not keep records it was supposed to keep as mandated by the Exchange Act.
2) Prior to August 2012 UBS granted access to UBS order book data to 103 employees working in IT who had nothing to do with the operation or compliance of the actual dark pool.
3) UBS created a PPP order type geared towards high speed market makers. It was only disclosed to select market makers, and not to all other subscribers (institutions).
4) UBS’s PPP order type provided for sub-penny pricing in violation of Rule 612. This order type helped UBS have a large competitive advantage over other dark pools that did not break the law.
5) UBS had a faulty suite of algos (PTSS) that routed sub-penny orders to its own dark pool, as well as to other third party dark pools. UBS knew it was faulty, but decided not to fix it, because an eventual new algo suite (Rainier) was only two months away, and likely bug free. Two months became six months.
6) UBS created a “natural only crossing restriction” geared for the buyside, where buyside clients could choose to not interact with “non-naturals”. UBS decided who was natural vs. non-natural. This was neither disclosed to all subscribers, nor made available to all subscribers.
There are, of course, interesting details in the SEC –UBS Cease and Desist Order.
For example, some senior UBS ATS employees purposely removed references to the HFT-oriented PPP order, as well as the “natural only” order, from presentations and client communications:
“I took out references to our % of spread and non-natural vs natural as well because that stuff is very proprietary and changes… It’s something we should talk to rather than put in the slide….”
UBS also sent a spreadsheet with proprietary client information that broke down Subscriber C’s (an HFT firm) trades the prior two days, and added information about which trades were retail, and which were not. The UBS employee knew that Subscriber C would use the secret information to change its algos to try to be on the other side of more retail orders, which would increase UBS’s volume as well.
And with regard to the natural crossing restriction UBS created, UBS employees seemed to acknowledge some amount of toxicity of HFT order flow; they were concerned about shielding their own algos from it, but not all players in their pools:
In a January 2010 email, a UBS employee responsible for its algorithmic trading products wrote that the firms to be “tagged as ‘non-natural’” were mainly “high frequency firms and market makers” and that initially we do not want to expose our discretionary dark liquidity to this flow.”
Even non-malicious portions of these UBS findings are troublesome. The SEC seems to care about trading venues keeping their systems robust and bug free. UBS knew it had sub-penny routing issues, and chose to not fix them for their own cost concerns. Do venues that do this, that trade billions of shares, deserve to have a license to continue to do so?
UBS has said that these issues have been fixed since 2012.
Some Points to Ponder
First, what took the SEC so long? The SEC wanted to bring dark pools into a stricter regulatory regime as far back as 2009. You may recall their 2009 Proposed Regulation of Non-Public Trading Interest. In that proposal, the SEC wanted to:
– Increase post-trade transparency by having dark pools identify their trades on the consolidated tape just as the exchanges do (Z, T, K, N, A, Y etc.)
– Regulate actionable IOIs – call them what they are – orders, yet still provide exemptions from display for “blocks.”
– Lower the 5% threshold to 0.25%.
Even then the SEC was concerned about two-tiered and unequal access to pricing in dark pools, and in general. Yet their proposal met so much industry pushback from the brokers and dark pool operators that they did not act. Perhaps the SEC should shoulder some of the blame for the degradation of ethical practices in trade execution. After all, if a regulator sits on the sidelines and watches without passing any industry rules or guidance, they should not be surprised when the markets turn into Lord of The Flies.
Second, they most certainly have been alerted to potential unsavory practices by many well-meaning industry participants. Who is next? Are UBS’s practices isolated? Perhaps there are more SEC actions to come.
Third, and consistent with what Themis has said for years, the trend towards segmenting customers by alpha, and cherry picking how each segment is “touched”, is a dangerous one – especially in a world with rampant payment for order flow. Fair markets, markets geared towards accurate price discovery, and safe robust markets… are ones where all participants have the same rules and interact equally with each other, unfettered and un-intermediated.
Lastly, the time has come for the SEC to act with consistency. Think about this for a second: why is the SEC ok with meaningless price improvement and sub-penny prices that disadvantage resting liquidity with wholesalers (like Citadel and even UBS), but not ok with it when it is done in a dark pool? It is a poor and damaging practice no matter where it is conducted!
Let’s close today’s note by watching UBS’s Vlad Khandros on Bloomberg Market Makers talking about the aftermath of Michael Lewis’s Flash Boys:
Note the 3:04 mark, where Erik Schatzker postulates to Mr’ Khandros that Flash Boys has helped the investors by increasing the level of transparency in the industry. How does Mr. Khandros respond?
“Look, let’s take a quick step back right? So costs of trading now, no matter who you are and how you measure it, it’s down by a vast amount…”
Yeah… we hear that response often; it’s a splendid deflection.