Although a believer in the unfettered free market might tell you that new tools and practices cannot be ‘uninvented’, many a regulator will cite with glee the activities that they have ruled out of existence. Indeed, the attitude of the US Securities and Exchange Commission (SEC) to actionable indications of interest (IOIs) suggests a desire to put this particular genie firmly back in its bottle. But it may also prevent the market from racing up an evolutionary cul-de-sac.
The SEC wishes to outlaw the practice of US dark pools transmitting information about attractively-priced orders to a select group of users via actionable IOIs, because it believes that the result is a two-tier market. The SEC points out that the information contained in actionable IOIs “are intended to attract immediately executable order flow to the trading venue” and so bear little difference to the function of bids and offers on a lit exchange. As such, the regulator proposes to amend the definition of ‘bid’ or ‘offer’ in Regulation NMS to apply explicitly to actionable IOIs. This, it hopes, will ensure fair competition among exchanges by putting all pre-trade information in front of the whole market.
The SEC’s European counterpart, the Committee of European Securities Regulators (CESR), may take similar action, having recently asked market participants for their views on topics such as, “Do you consider that MiFID should be amended to clarify that actionable IOIs should be subject to pre-trade transparency requirements?”
Dark pool operators in the US and Europe may soon have to decide whether they continue to advertise their wares via actionable IOIs or rely on other means of ensuring high levels of order flow and similarly robust matching rates. But regulatory intervention may also steer market participants away from an apparent path to innovation that could in fact turn out to be a dead end.
After many years of anticipation, the truly actionable IOI – in which an order is launched by clicking on an IOI on a trading screen and the broker is obliged to meet the price – does actually exist. But so far very few brokers have viewed the opportunity as outweighing the risk. In the US, both Reg NMS’s explicit commitment to execution at best price and the unknown opportunity cost of committing to a particular price for a particular client, while prices rush up and down on the open market, make dealing in actionable IOIs an uncertain occupation.
More importantly perhaps, as the SEC has noted, making IOIs actionable takes away their unique selling point. As one observer noted recently, “It’s all but impossible to represent the size that institutional investors want to deal in through any other mechanism.”
By definition, IOIs provide an indication of the current level of market interest in a stock at a certain size. Technology has made usage self-policing in that alerts can be sounded for IOIs in specific names and indications can be run through transaction cost analysis data to assess value. Moreover, buy-side traders can ban brokers if they misrepresent toxic orders as ‘natural’ flow.
But perhaps this is as far as evolution should come. IOIs have one foot in the past, but this may be no bad thing when they provide such colour and nuance in a market dominated by the binary decision-making process of machines. By pruning back IOIs, the regulators may have allowed them to flourish.
To vote in this month’s poll on IOIs and pre-trade transparency, click here.