SEC Concerned About Post-Trade Transparency of Dark Pools

The SEC has become increasingly concerned about the post-trade transparency of dark pools, which are electronic trading systems that do not display public quotes. According to James Brigagliano, Co-Acting Director of the Division of Trading and Markets, this lack of post-trade transparency can make it difficult for the public to assess dark pool trading volume and evaluate which ones may have liquidity in particular stocks. In keynote remarks at a recent SIFMA seminar on market structure, he also examined the potential effect of dark pools on the public price discovery function.

Public quote streams are distributed by central processors that act on behalf of all the SROs in making market information widely available to the public. Over the last year, dark pools, which do not display public quotes, appear to have increased their percentage share of total trading volume in US-listed stocks. But the SEC official noted that there is very little reliable public information on dark pool trading activity. He said that this lack of public information illustrates a transparency concern that warrants attention. Dark pools report their trades to the consolidated public trade streams, but their trades are identified merely as non-exchange, or OTC, trades. The public trade reports do not identify whether an OTC trade was reported by a dark pool and, if so, the identity of the dark pool.

Although many dark pools publicize volume statistics on their web sites, he noted, they do not use a uniform methodology and may effectively overstate their true executed volume because of double counting of both the buy and sell side of a single trade or by including touched volume of orders routed elsewhere for execution with the matched volume that they actually execute. The official is concerned that this state of affairs may not promote public confidence in the equity markets.

There does not appear to be a particularly compelling reason for dark pools to object to improved post-trade transparency. While full pre-trade darkness is an important element of the business model of some dark pools, he said, it does not appear that some form of improved post-trade transparency would interfere with their business models. Indeed, uniform and reliable trade reporting practices could help establish a fairer playing field because those dark pools that report their volume accurately would not be disadvantaged in comparison with any that might inflate their volume.

The SEC will consider whether the post-trade transparency of dark pools should be enhanced. A key question is whether this type of information would be useful to investors and, if so, what is the best vehicle for disseminating the information. For example, Mr. Brigagliano queried whether trade-by-trade disclosure by dark pools would be most helpful, or would the public availability of more uniform, reliable summary statistics on trading volume be sufficient.

Another regulatory concern with respect to many dark pools relates to their transmittal of pre-trade messages about their available liquidity. Although dark pools do not publicly display quotes, he observed, many nevertheless are not entirely dark on a pre-trade basis. In an effort to attract order flow, many dark pools transmit messages to selected market participants notifying the recipient that the dark pool currently has an actionable order in a particular stock, that is, an order that currently is available for automated execution. One of the regulatory issues that former Director Erik Sirri earlier noted was the potential for such messages to fall within the regulatory definition of a "quote." Most dark pools label their pre-trade messages as indications of interest, or "IOIs."

Focusing on the policy implications of actionable order messages and whether they raise any market structure concerns, Mr. Brigagliano said that, given the speed and sophistication of order routing and trading systems, private actionable order messages are functionally and economically similar to public quotes. The systems are incredibly fast, he added, and both actionable order messages and quotes can be transmitted and responded to within a few milliseconds. Although a public quote always will have an explicit price, an actionable order message is implicitly executable at the national best bid and offer or better.

Dark pools that use actionable order messages typically transmit them to networks of selected market participants. As a result, said the official, the widespread use of actionable order messages could create the potential for significant private markets to develop that exclude public investors. In particular, these private markets could wind up representing a significant volume of trading based on valuable information on actionable orders to which the public does not have fair access.

Another aspect of actionable order messages the SEC will consider is their potential effect on competition among trading centers and market fragmentation. Erik Sirri suggested last year that competitive forces seemed particularly apt to address the problem of fragmented dark pools. He noted that the users of dark pools seemed likely to pressure their operators to consolidate the pools to enable users to check liquidity more efficiently. Mr. Brigagliano noted, however, that actionable order messages are used by the operators of dark pools to alert users when they have liquidity and thereby may weaken this competitive force for consolidation. If actionable order messages enable many small pools to survive separately, he added, market fragmentation could worsen.

Finally, the co-director discussed the potential effect of dark pools on the public price discovery function. It is possible that a substantial increase in dark pool volume could impair the public price discovery function by diverting valuable marketable order flow away from the exchanges that contribute to the public quote stream.

The official distinguished between two major types of dark pool trading mechanisms: block crossing systems and small order systems. Block crossing systems focus on arranging large trades between institutional investors. With an average trade size as high as 50,000 shares, block crossing systems offer significant size discovery benefits to their participants, though they currently appear to execute a small percentage of dark pool trading volume.

Small order systems, in contrast, appear to execute the great majority of dark pool volume and to be the fastest growing type of dark pool. They also may have the greatest effect on price discovery in the public markets. In particular, they may attract a significant volume of very desirable small marketable order flow away from the public markets.

This type of marketable order flow is desirable for those who supply liquidity through resting, non-marketable orders. To the extent desirable order flow is diverted from the public markets, reasoned the SEC official, it potentially could adversely affect the execution quality of those market participants who display their orders in the public markets. The Commission is concerned that any practice that significantly detracts from the incentives to display liquidity in the public markets could decrease that liquidity and, in turn, harm price discovery and worsen short-term volatility.