The actionable indication of interest (IOI) is a long-held buy-side traders’ dream, but its realisation will take a backward step if regulators have their way.
Truly actionable IOIs – i.e. bids or offers for a stock that can be executed on a point-and-click basis – are not yet widely available. But operators of non-displayed liquidity venues regularly use IOIs that provide full details of attractively-priced orders within their dark pools to drum up business and improve crossing rates. Not only does the sending out of ‘all but actionable’ IOIs compromise the claim to total opacity on the part of certain dark pools, it also – from the perspective of regulators – raises the risk of a two-tier system in which favoured market participants benefit from information not provided to all.
In October, the US Securities and Exchange Commission (SEC) announced a plan to alter the definition of bids and offers in Reg NMS to include actionable IOIs as part of a three-pronged overhaul of dark pool disclosure rules. This proposal would place actionable IOIs on the national US pre-trade consolidated market data feed, making the information available to all market participants. Feedback on the proposal closed in February but the SEC has yet to finalise a new rule. The SEC’s other two dark proposals would force real-time disclosure of dark pools’ identities in the US post-trade consolidated feed and lower the threshold at which certain trading platforms must display bids and offers to 0.25% of a stock’s average daily volume from 5%. Block trades – defined as those above US$ 200,000 – would be exempt from all proposed rules. And this month, pan-European securities regulator CESR (Committee of European Securities Regulators) issued a call for evidence into “microstructural” market issues on technology-led market innovations such as high-frequency trading, sponsored access and actionable IOIs. So is it RIP for the IOI?
In truth, IOIs have had a troubled history as well as an uncertain future. Originally a fairly labour-intensive means by which a broker might identify the other side of a client’s order, IOIs grew in volume if not necessarily quality as the trading process became increasingly electronic. Although the number of IOIs arising from genuine client need increased, their growth was exceeded by the volume of speculative messages sent out by the sell-side to gauge market sentiment, many of which were irrelevant to the day-to-day trading priorities of the buy-side recipients.
Despite this, the canny buy-side trader would still try to keep an eye on the flow of IOIs in case they offered the opportunity to deal at a better price than prevailing market rates. Further advances in technology made it easier for the buy-side to utilise IOIs, such as FIX-based integration of IOI messages into order and execution management systems. IOIs remained negotiated transactions on the whole, but tools developed to help brokers be smarter and more targeted in their use of IOIs, which improved the probability of execution and hence the buy-side’s comfort levels.
The next step in the evolution of IOIs was to prove more controversial. As an added-value service, dark pool operators began to send out liquidity alerts to other dark pools and liquidity providers to improve the chances of orders being executed, externally if necessary, thereby attracting further order flow. But the growth in dark pool trading (around 8-10% of overall cash equities volume in the US, by most estimates, and less than 4% in Europe), has encouraged regulators to take a closer look at all aspects of non-displayed trading to ensure that they represent no unfair advantage to particular groups of market participants.
The SEC is categorical in its belief that allowing actionable IOIs to advertise better prices in dark pools than are available on lit venues is detrimental to the interests of the wider market. “The Commission is concerned that the private use of actionable IOIs may discourage the public display of trading interest and reduce quote competition among markets,” it wrote in its October 2009 proposal. CESR acknowledges differences between the US and European equities markets, but the regulator is nevertheless keen to establish whether the distribution of actionable IOIs to select market participants compromises MiFID’s overarching principle of pre-trade transparency for regulated markets and multilateral trading facilities.
Banning dark pools from advertising liquidity via actionable IOIs will not necessarily bring to an end the more informal way in which the buy- and sell-sides use IOIs to communicate potential interest in particular blocks of stock. But given the greater scrutiny of trading practices in the wholesale markets, institutional investors might do well to monitor developments closely in case a crackdown on actionable IOIs turns out to be the thin end of the wedge.
To vote in this month’s poll on IOIs and pre-trade transparency, click here.