US dark pool regulations on ice as volumes grow

Dark pools are expected to take a larger share of US equity trading volumes in 2011 following a 30.7% increase last year, but further rises may be stymied by a long-awaited regulatory clampdown.
By None

Dark pools are expected to take a larger share of US equity trading volumes in 2011 following a 30.7% increase last year, but further rises may be stymied by a long-awaited regulatory clampdown.

According to US broker Rosenblatt Securities' annual report on US dark trading, non-displayed transactions made up 13.27% of consolidated US equities trading volume at the end of 2010, up from 10.15% at the end of 2009. Rosenblatt predicts dark trading will reach 15% by the end of 2011. Meanwhile new rules proposed over a year ago to regulate dark order flow, are seen as on hold until the end of 2011.

Lower volatility is suggested as a contributing factor to the rise. Rosenblatt observed a strong negative correlation between volatility – as measured by the Chicago Board Options Exchange's volatility index (VIX) – and dark pool volumes throughout 2010, with November the only exception. Justin Schack, director of market structure analysis at Rosenblatt, predicted the downward trend of volatility would likely continue in the medium term.

The Rosenblatt paper, which captures data from 16 major non-displayed US trading venues, posits several theories for the correlation: a preference among traders and portfolio managers for trading over shorter time horizons when volatility is higher; the increased importance of price discovery in volatile markets; and a perception that lit exchanges' systems are faster / more reliable and thus safer in unstable market conditions.

The firm also observed that US dark pools have begun offering co-location, low-latency connectivity and faster matching engines to attract high-frequency trading (HFT) firms which could also have contributed to increased volumes.

Quashing the dark

Concern about the increase of trading in dark pools led the Securities and Exchange Commission (SEC), which regulates the US securities markets, to propose a three-point plan on 29 October 2009: lowering the threshold at which alternative trading platforms must display bids and offers to 0.25% of a stock's average daily volume from 5%; introducing real-time disclosure of executions by all venues; and bringing reporting in line with registered exchanges.

The SEC supplemented these proposals in its equities market concept release on 13 January 2010, which floated the idea of a ”trade-at' rule which would prevent non-displayed venues from matching at the national best bid and offer (NBBO), and instead proposed that they should either match at a significantly improved price e.g. by the minimum tick size, or should route orders to a displayed venue that could complete the trade at the NBBO. The rule would prevent trades from being crossed in dark pools when that offered no advantage over crossing in a lit venue, but limited price formation.

However these proposals have been frozen, as regulators focus on implementing the many rules that were put in place by the Dodd-Frank Act, which came into law in July 2010. “There's been no official word, but we expect that they would put out a concept release again toward the end of the 2011,” said Tim Mahoney, CEO of US dark pool BIDS. “It may be altered to take into account what has happened since the proposals first came out. We think it will be a more general proposal rather than just focussing on dark pools.”

Price improvement needed

Schack agreed that regulators are likely to begin to reconsider dark pool regulation at the end of 2011, but said that the 2009 proposals “wouldn’t have much of an effect at all”, noting the most onerous, and unpopular, post-trade transparency rule would likely be changed under industry pressure.

“The trade-at rule absolutely would have an effect and it would go beyond dark pools,” he said. “Regulators all around the world are talking about limiting internalisation. International, European and Canadian regulators are all saying it should be limited unless it offers price improvement. I think if the SEC does take this up in 2011, this will be angle it will take.”

Vlad Khandros, a member of the corporate strategy group at buy-side block trading venue Liquidnet, predicted that the SEC would distinguish between different types of venue in any moves to tighten regulation of dark trading. “We believe [regulators] will draw a line in the sand between venues handling large orders and the broker venues that typically handle very small orders,” he said.

A restriction could affect a significant portion of the US market, warned Schack, including automated market makers operating in broker-dealer dark pools which balance some retail and institutional flow on one side, with HFT flow on the other. “The HFT market maker gets access to this juicy flow that’s not going to the exchange, or at least before it does. I think that portion of it would be affected by ‘trade-at’,” he said. Schack suggested that market makers offering execution services to retail brokers could also be impacted. “They pay for the order flow and execute it at or close to the spread with minimal price improvement. That’s about 15% of the total US market,” he added.

However Khandros does not expect dark trading activity to be suppressed overall, saying, “I would expect to see market participants encouraged to create their own lit books in the US, if regulation went through that made it difficult to trade off-exchange.”

Firms are already moving in this direction. Global broker Credit Suisse announced in January that it will launch an electronic communications network, Light Pool, at the end of Q1 2011, which will offer a fee structure and order types that are preferential to buy-side long-only traders, while exchange group Nasdaq OMX launched PSX in November, a price/size priority trading venue that rewards those trading in size, rather than those that have the fastest technology.