Global Exchanges Ask G-20 to Address Dark Pools and Absence of Level Playing Field

The world’s major financial exchanges have asked the G-20 to examine two interconnected problems that could compromise the ability to extend exchange best practices to OTC markets as part of regulatory reform. The first concern is the absence of a level playing field between exchanges and other entities performing some of the same or similar functions. The second concern is an erosion of price discovery and dark pools, arising from recent trends. The concerns were voiced in a letter to the Financial Stability Board, which the G-20 has designated as a key player in assuring the cross-border consistency of financial regulation legislation. The letter was signed by William Brodsky, CEO of the CBOE, in his role as Chair of the World Federation of Exchanges. It was endorsed by, among others, NASDAQ, NYSE Euronext, the London Stock Exchange, and the Tokyo Stock Exchange.

The exchanges urge the G-20 to assure a level playing field for the responsibilities assumed by all securities order execution venues. In many jurisdictions, said the exchanges, the introduction of alternative order execution platforms has led to significant internalization of order flow and related practices.

These practices limit the visibility of orders, hampering investors' ability to respond to them and diluting the price discovery process. These practices also reduce the ability of both market participants and regulators to see overall market activity and may impact the conduct of proper market surveillance. The letter quoted a former director of the SEC's Division of Trading and Markets as pointing out, "we want the benefits of competition, but without the adverse effects of fragmentation."

The exchanges support the benefits of competition, but acknowledge that fragmentation, if not properly managed, may have harmful effects on market efficiency, financial stability and investor protection. In their view, a central and transparent price discovery process is at the heart of every sound market whereas fragmentation, when its design facilitates a lower level of transparency, hinders this process.

At the end of the day, all investors need to have confidence in the reliability of information reflected in the prices at which securities transactions occur. The exchanges fear that the heightened opacity of certain trading venues inhibits price discovery and may lead to negative outcomes, inc1uding increased market volatility.

The global exchanges believe that the current environment is creating an unequal distribution of the costs of providing a capital markets infrastructure at the expense of regulated markets and to the advantage of alternative trading venues. While welcoming competition, the exchanges say that it should not be structured in ways that can affect the quality of market operations and the soundness of the price discovery process.

The letter also examined the impact of dark pools on market transparency; and asks the G-20 to consider this issue. The SEC has also 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.

According to the exchange, a question has arisen over the right of markets participants to trade without providing visibility on prices and quantities to other market participants, in order that their orders are executed without moving the market against them. Recently, some exchanges have accommodated these demands by creating order types or opening segments allowing trading that is not immediately visible to the rest of the market. In the case of exchanges, this trading is nonetheless tied into the visible market's surveillance and position-monitoring in order to assure the oversight of total market operations.

Other execution venues also offering dark trading in so-called "dark pools," but their trading and clients' positions are not visible for surveillance purposes. Regulators have no way to evaluate the risks which may be inherent in the combined on-exchange/off-exchange dark pool activities, nor what effects they might have on the visible markets.

Taken together, the combination of the absence of a level playing field between execution venues and decreased market transparency is an unsettling development. The policies and practices that exchanges have developed to ensure fair, orderly markets are at risk of becoming less meaningful and less available to investors and listed companies.

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