Signs of greater dark transparency

The US finance industry's self regulatory body has approached dark pool operators for evidence of how, where and with whom client orders are routed, to better monitor transparency – but key industry figures concur regulators must proceed cautiously.

The US finance industry's self regulatory body has approached dark pool operators for evidence of how, where and with whom client orders are routed, to better monitor transparency – but key industry figures concur regulators must proceed cautiously.

The Financial Industry Regulatory Authority (FINRA) last month sent letters to alternative trading system (ATS) providers in the US seeking detailed answers on these topics and how clients were made aware of this information as part of efforts to address transparency within dark pools.

This round of letters is a follow up to an initial round of questions from FINRA last year. Responses can lead to enforcement action or recommendations for dark pool operators, although the initiative signals wider scrutiny of dark pools by US regulators.

Anthony Fortunato, managing director at agency-broker Instinet, which operates three US dark pools, believes regulators are correct in showing concern over order types and should identify whether specific orders types and pools of liquidity actually benefit the market.

"Regulators should be asking why a participant would need a certain dark pool or order type and decide if that reason is consistent with the principle of fair and orderly markets," he said. "If not, they should disallow them and try to bring a higher concentration of orders back into normal execution venues and order types."

The results of a dark pool survey conducted by's quarterly magazine, The TRADE, and released this year's Q2 issue, reveal the leading priority of dark pool users is controls over toxic flow. This option was selected by 82.4% of respondents, from eight choices. Conversely, latency, number of securities traded and market microstructure were all chosen by under 30% of near 300 buy- and sell-side respondents.

Shady trend

Dark pools remain a highly contentious subject for market participants and regulators alike. A three-point plan developed by the Securities and Exchange Commission (SEC) in 2009, which never came to fruition, may be rejuvenated, with a December session on dark trading held by the Committee on Banking, Housing and Urban Affairs subcommittee on Securities, Insurance and Investment, quizzing dark pool operators about trade practices.

Meanwhile in May, the SEC gave a strong signal it may address Reg NMS - a set of rules that has indirectly shifted lit flow onto dark pools. This regulatory regime has attracted intense contestation between exchange and dark pool operators.

The former have pushed for a 'trade-at' rule, whereby trades must execute in dark pools only if a minimum amount of price improvement is offered in a dark pool. This would significantly alter the landscape of US equity markets, with dire results for ATSs.

"A trade-at rule would be a fairly severe regulatory measure and I think regulators need to look beyond the intentions of market participants supporting it," said Brian Carr, co-head of sell-side sales for ConvergEx, which operates two US dark pools.

Although Carr doesn't anticipate the formation of a trade-at rule in a Reg NMS overhaul, he believes any new dark pool rules must reflect the fact both dark and lit liquidity benefit the market and that regulators should consider the effect of new rules on specific market participants - not just exchanges seeking to claw back volumes.

Data mine

Any regulatory changes to US dark pool rules may also hurt those they are designed to protect, warns Ari Burstein, senior counsel for US buy-side trade body the Investment Company Institute.

"A balance needs to be drawn with any new regulation, we don't want to see over-prescriptive rules forcing brokers to limit use of technology the buy-side uses or shift the costs of compliance to the buy-side," he said.

Burstein contends that for institutional investors, the venue itself holds little importance and all that maters is the operation of efficient, orderly markets, which he believes is driven in large part by the choice offered by brokers.

Despite this venue agnosticism, the buy-side has become increasingly aware of broker routing decisions, and the link to information leakage, which can push overall trading costs up. But this appears a subject the industry has itself tackled well.

"We don't see any need for policymakers to get involved with broker routing decisions at this point," Instinet's Fortunato believes. "Instead, the buy-side should continue to push for transparency in this regard by requiring regular reports and clearly articulating upfront what should and should not be done with their orders."

Fortunato's comments were mirrored by ConvergEx's Carr.

"We don't need proscriptive rules about exactly what data must be sent to clients - the industry should, and has shown to, drive client data requirements and the sell-side has reacted well to the growing interest in data from buy-side firms," he said.