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Stock Exchanges Seek Curbs on Dark Pools to Fight Exodus

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Stock Exchanges Seek Curbs on Dark Pools to Fight Exodus

Three large U.S. stock exchanges are lobbying for new limits on dark pools and other competitors, arguing that too much trading has become hidden on private venues that create more cost and volatility in public markets.

Chief executive officers of NYSE Euronext (NYX) Inc., Nasdaq OMX Group Inc (NDAQ). and Bats Global Markets Inc (BATS). have met in Washington over the past two months with lawmakers and the Securities and Exchange Commission. They’ve asked for a rule that could divert more orders to exchanges rather than trading in dark pools or within a broker’s inventory.

The exchanges say that more than a third of all stock transactions now occur without pre-trade prices being made public, up from 16 percent in January 2008. They are pressing the SEC to make market restructuring a priority as the agency resets under its new chairman, Mary Jo White.

“We are protecting the sanctity of the public quote, and you can expect us to continue to protect it with meetings we’ll be having and raising awareness of the issue in a very public way,” NYSE CEO Duncan Niederauer said in an interview.

The lobbying comes several years after the SEC began adding controls to grapple with technology that has made markets faster with lower trading costs while also more fragmented and prone to software errors. The regulator on May 29 fined Nasdaq $10 million for the failure of computer systems in Facebook Inc (FB).’s mishandled initial private offering last year, which brokers say cost them almost $500 million.

Trade Size

Dark pools, which don’t publish bids or offers on shares, were set up to allow large investors to trade big blocks without having news of their orders move the price. NYSE and its peers contend that the original rationale no longer applies because, they say, the average trade size in dark pools has fallen to about 200 shares. As a result the private venues are becoming less-regulated versions of traditional exchanges, they said.

SEC rules currently protect investors from receiving a worse price than the best available bid or offer. The exchanges want the SEC to pass a “trade-at” rule, which would require brokers to route an order to an exchange unless they can improve on the best public quote by a defined amount. Since Canada imposed such a rule last year, quoted spreads and volatility have fallen, the exchange’s CEOs told White during a presentation May 1.

Brokers and operators of dark pools are trying to blunt the lobbying campaign, saying there’s no evidence that off-exchange trading hurts investors. Academic studies of fragmented markets have come up with varying results. Some found that dark trading is associated with wider bid-offer spreads on stocks and higher levels of volatility, while others have concluded it’s associated with lower transaction costs and better prices.

‘Less Accountability’

Officials from Morgan Stanley (MS) met in Washington May 22 with SEC commissioners and staff, as well as Wall Street’s self-regulator, the Financial Industry Regulatory Authority. They said a trade-at rule would reduce options for customers who want to prevent orders from leaking to the rest of the market.

Niederauer made the case for new rules in an April 29 letter to NYSE-listed companies, saying that off-exchange trading operates “with less regulatory oversight or accountability.”

In addition to dark pools, other trading happens in private when brokers are paid to send their most profitable orders from retail investors to wholesalers, which handle the transactions within their own inventory. Brokers say the practice allows them to give retail investors slightly better share prices, as well as research reports and insurance against technology malfunctions and order errors.

Order Flow

Wholesalers that fill the orders seek to provide as industry practice a price that is at least one-tenth of a penny per share better than the public quote, according to a person familiar with the system who spoke on condition of anonymity. Exchange officials say that isn’t enough savings to justify filling the order away from the public market.

Exchanges say this practice, known as payment for order flow, creates conflicts of interest for brokers and leaves exchanges with the leftovers -- orders from better-informed investors such as high-frequency traders and hedge funds who bet on short-term price directions. More business from small investors would help balance order flow and result in better prices and less volatility, the exchanges say.

John Nester, an SEC spokesman, declined to comment on the lobbying.

Talking Book

White, who became SEC chairman in April, has said one of her goals is to “fully understand” whether retail investors are hurt by technology-aided innovations including dark pools, which unlike exchanges, don’t have to treat all customers the same. A person briefed on the matter, who spoke on condition of anonymity because the effort isn’t public, said the SEC wants to review why so much trading has moved away from exchanges in recent years.

Still, SEC officials have displayed caution about diving into structural changes that could upend the way certain investors are treated.

“We have to show a certain amount of skepticism because everyone is also talking their book,” James Burns, the SEC’s deputy director of trading and markets, said at a May event sponsored by the Securities Industry and Financial Markets Association, Wall Street’s largest lobby group.

Dark pools and other non-exchange trading accounted for 25 percent of volume when the SEC issued a paper on market structure in January 2010. Now it’s 36 percent, according to data from Rosenblatt Securities Inc., an institutional broker. Dark pools account for about 14.7 percent of the volume. Bloomberg LP, parent of Bloomberg News, owns a stake in a company, Bids Trading LP, which operates a dark pool.

Market Share

Larry Harris, a former chief economist at the SEC, said the exchanges haven’t made the case that today’s volume of dark trading is hurting the quality of public markets. Transaction costs, for instance, have fallen significantly since 2004, according to data provided by agency brokerage Investment Technology Group, which operates a dark pool.

“The exchanges are hurting in the sense that their market share is dropping off, but the overall quality of the prices has not dramatically fallen off,” said Harris, who sits on the board of directors of Interactive Brokers Group Inc (IBKR)., an electronic market maker and broker.

The idea of a trade-at rule has come up before from NYSE and Nasdaq and was raised by the SEC in a 2010 paper. In February 2011, the idea won approval from an SEC advisory committee charged with supervising emerging regulatory risks. The proposal was put on the back burner as the SEC switched its focus to rules mandated by the Dodd-Frank Act and responses to the sudden plunge in stock prices in May 2010, which briefly wiped out $862 billion in market value in less than 20 minutes.

SEC Refocus

“Now that you have some bandwidth freed up, the SEC is starting to refocus on some market-structure issues,” said Christopher Nagy, a consultant and lobbyist who was previously managing director of order routing at TD Ameritrade Holding Corp.

Justin Schack, Rosenblatt’s managing director, said entities with something to lose under a trade-at rule would try to neutralize the proposal.

“Wholesalers and markets makers have really been making their voices heard on this because it is so critical to their profits and business models,” Schack said in an interview. “If we saw a serious, concrete proposal on the table, that would only intensify.”

Morgan Stanley (MS) executives argued a trade-at rule would be “an over-reaction” and take away options that customers value, according to the firm’s May 22 presentation at the SEC.

Aggressive Shopping

In lieu of a trade-at rule, regulators could limit brokers and exchanges from aggressively shopping around orders they can’t fill internally in order to avoid transaction costs, said Bill Neuberger, Morgan Stanley’s global co-head of electronic trading. Many of those orders would make their way onto exchanges, according to Morgan Stanley.

“It would have the effect of trimming down that 35 percent somewhat, but it would keep intact what we call the good dark trading,” Neuberger said.

Regulators also should require more disclosure in order to measure where dark volume comes from, Morgan Stanley officials said.

Exchanges, for instance, compete with dark pools by allowing investors to conceal part of their orders. An “iceberg” order displays only a portion of shares, keeping the rest hidden until the advertised amount is filled. Rosenblatt has estimated that hidden order types on exchanges account for 4.6 percent of U.S. equity volume.


“We are asking for more transparency,” said Sapna Patel, head of Morgan Stanley’s Americas market structure and liquidity strategy.

NYSE has sought to mute opposition among brokers by offering to lower the fees brokers pay to execute trades “in exchange for something that forced more volume to respect the public quote,” the exchange’s chief operating officer, Lawrence E. Leibowitz, said at a May 13 congressional roundtable.

Such a move could create “more of a desire to do a give and take around trade-at,” said Eric Noll, executive vice president of transaction services in the U.S. and U.K. for Nasdaq OMX.

Besides White, executives from the exchanges have met with Senator Jon Tester, a Montana Democrat who sits on the Senate Banking Committee, and with committee staff members.

While the exchanges want lawmakers to urge the SEC to consider new regulations, Democratic and Republican lawmakers are wary of wading into a fight among competitors, according to two congressional aides who spoke on condition of anonymity because the meetings were private.

Splintered Front

The exchanges’ united front in Washington has been splintered by opposition from Direct Edge Holdings LLC, owner of the third-largest exchange by volume, which executes more retail orders than many of its competitors and whose owners include dark-pool operators Goldman Sachs Group Inc. Knight Capital Group Inc (KCG). and Citadel LLC.

“The SEC is still diagnosing what the issues are. They are not convinced what needs to be fixed, if anything,” said Thomas McManus, chief compliance and regulatory officer for Direct Edge.

Schack of Rosenblatt, whose firm estimates U.S. dark-pool trading, said at the May conference that a more centralized market theoretically would yield better information about prices. But research doesn’t prove that more off-exchange trading is measurably harming market quality, Shack said.

“I ultimately don’t see a trade-at rule happening,” Schack said at the conference. “There is no guarantee we wind up in a better place for end investors.”

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