US broker-dealers that operate dark pools could be saddled with market making obligations following the publication of 14 recommendations to address market structure weaknesses exposed by last May's ”flash crash'.
Noting an absence of liquidity at times of high volatility from firms that internalise or preference order flow, the summary report into the flash crash by the joint Commodity Futures Trading Commission and Securities and Exchange (SEC) advisory committee called on the SEC to consider requiring internalising broker-dealers to execute “some material proportion of their order flow during volatile market periods”. As an alternative, the report suggested that the SEC should explore the possibility of adopting a proposed rule that would only allow internalised or preferenced orders to be executed at a price “materially superior” to the quoted best bid or offer.
Most major US institutional broker-dealers internalise client order flow via dark pools as a cheaper alternative to executing on exchange. The report estimates that one third of US share volume is executed on dark trading venues, but it explicitly excludes block trading venues from its recommendations. Preferencing typically refers to the practice of routing flow to a particular broker-dealer under payment-for-order-flow agreements. The 6 May flash crash wiped US$1trillion off the value of US stocks temporarily as draining liquidity caused orders to be executed at penny levels.
The joint report approved of measures already taken – such as the imposition of circuit breakers – but warned that these were insufficient due to “the absence of present incentives for market participants to provide liquidity”.
In addition to its recommendations on internalised and preferenced flow, the committee said the regulators should consider adopting a trade-at routing regime in which orders must be routed to one or more markets with the best displayed price. The committee argued that such an approach reinforces incentives to post displayed limit orders “and hence encourages the liquidity and price discovery roles of the market”. It also recommended a cost/benefit analysis of replacing the current ”top of book' protocol with “greater protection to limit orders placed off the current quote or increased disclosure of relative liquidity in each book”.
The committee also considered measures to ensure the flow of liquidity from high-frequency firms in times of high volatility. Although “chary of overdependence on market maker obligations as a solution” to low liquidity, the committee said there was some justification for asking firms responsible for high levels of traffic to “properly absorb the externalised costs of their activity”. As such it recommended that the regulators look at ways of fairly allocating the cost of high levels of cancellations, including a fee levied across exchanges based on traffic.