Dark pools brace for greater scrutiny in 2010

Non-displayed trading venues are viewed as the most likely recipients of more stringent regulation this year, according to the results of December’s TRADE Poll.
By None

Non-displayed trading venues are viewed as the most likely recipients of more stringent regulation this year, according to the results of December’s TRADE Poll.

When asked to identify the major regulatory changes that could be expected in 2010, 37% of theTRADEnews.com’s readers said tighter regulation of dark pools was on the cards during the next 12 months.

The remainder of the responses were fairly evenly divided between the other three categories, with 23% expecting a ban on ‘flash’ orders, 20% anticipating that regulators would call for more consistent transaction reporting by execution venues and 19% predicting a European clearing and settlement directive.

It is not surprising that tighter regulation of non-displayed trading has topped the list of expected action in 2010. The growth of dark pools’ market share of global equities trading – roughly 4% in Europe and 9% in the US – has prompted concerns about the potential effects of non-displayed trading on the quality of displayed quotations, which has in turn spurred regulators on both sides of the Atlantic into action.

The US Securities and Exchange Commission (SEC), for example, is currently seeking comment on its proposals to bring additional transparency to non-displayed trading, which include publishing actionable indications of interest in the public quote stream, reducing the threshold above which dark pools must display quotations and requiring non-displayed trading venues to be individually identified in the consolidated post-trade tape.

Dark pools are also likely to play a big part in the European Commission’s review of MiFID, which will be conducted this year. The Commission is expected to examine the continued relevance of the MiFID pre-trade transparency waivers that non-displayed venues use to avoid publishing quotes and the classification of broker-owned dark pools that are not currently registered as either systematic internalisers or multilateral trading facilities.

While flash orders, which display unfilled orders to specific participants on a venue for a few milliseconds before routing elsewhere, are effectively a US-only issue, the furore surrounding them has ensured that they remained at the forefront of traders’ minds leading into 2010.

Flash orders have been berated by regulators and politicians alike for creating a two-tiered equities market. The orders’ detractors argue that they benefit those with the money to invest in high-speed trading systems and proprietary data feeds at the expense of retail investors.

The SEC has proposed banning flash orders, with the comment period for its proposals closing on 23 November last year. But although the SEC’s proposals received strong support from many quarters, the banning of flash orders is far from a foregone conclusion – the practice was defended staunchly by the options trading community, which felt flash orders helped rather than hindered retail investors.

The lack of consistent trade reporting has been a particular issue for the buy-side in post-MiFID Europe, where traders are struggling to piece together a complete picture of trading activity across the continent, and also promises to be a focus of the European Commission’s MiFID review. The Commission has not ruled out the adoption of a consolidated post-trade price source similar to the system used in the US.

Although the implementation of a European clearing and settlement directive was the lowest on our readers’ list of expected regulatory actions for 2010, it is a near-certainty that such a piece of legislation will emerge in the coming years. In October 2009, the European Commission proposed pan-European clearing legislation as part of its desire to have more over-the-counter derivatives trading centrally cleared. It intends to complete draft legislation in 2010 and have regulation in place by 2012.

As regulators tighten regulations in a number of trade execution-related areas to boost public confidence in the financial markets, participants are keen that they avoid unintended consequences. Greater regulation of dark pools, for example, could diminish these venues’ usefulness as a tool for minimising market impact, potentially increasing the cost of trading for all – retail investors included. Many in the market are keen that regulators rigorously assess the effects on the entire market before making changes to individual components.

To vote in the new poll on trading volumes, please click here.