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November 24, 2009 |
Schiff Hardin LLP Securities and Futures Regulation Group Update SEC Action on Dark Pools On November 13, 2009, the Securities and Exchange Commission issued a proposal to amend various rules applicable to Alternative Trading Systems ("ATSs") under the Securities Exchange Act of 1934. Although these amendments would apply to all ATSs, many of the changes are directed toward so-called "dark pool" ATSs (that is, ATSs that do not display their trading interest in the public quote stream). If adopted, these changes would: (1) amend the definition of "bid or offer" to include "actionable" indications of interest ("IOIs") shown by an ATS to a select group of market participants so that such actionable IOIs will be subject to applicable quoting obligations; (2) lower the trading volume threshold in Regulation ATS under which ATSs are required to publicly display their orders and actionable IOIs; and (3) amend the joint industry plans for publicly disseminating consolidated trade data to require real-time disclosure of the identity of the executing ATS on trades executed by an ATS. See Exchange Act Release No. 60997 (Nov. 13, 2009), 74 FR 61208 (Nov. 23, 2009). Comments are due by February 22, 2010. The proposal would amend the definition of "bid" and "offer" in Rule 601 of Regulation NMS, which currently excludes all IOIs, to exclude only IOIs that are not "actionable." The Commission does not propose to define an "actionable IOI" in any rule or regulation; instead, it merely provides a description in the proposing release of when it believes an IOI would be considered "actionable." In this regard, the proposal broadly states that an IOI would be considered actionable "if it explicitly or implicitly conveys all of the following information about available trading interest at the IOI sender: (1) symbol, (2) side (buy or sell); (3) a price that is equal to or better than the NBBO (the national best bid for buy orders and the national best offer for sell orders); and (4) a size that is at least equal to one round lot."1 It further provides that "[i]n determining whether or not an IOI conveys this information, all of the facts and circumstances surrounding the IOI should be considered, including the course of dealing between the IOI send and the IOI recipient." Under the proposed rule amendments, an ATS that displays actionable IOIs to more than one person (if it meets the applicable trading thresholds, discussed below) would be subject to the quoting obligations in Rule 602 of Regulation NMS and Rule 301(b)(3) of Regulation ATS, as well as rules against locking and crossing markets. The SEC has also proposed an exception from the definition of "bid" or "offer" for IOIs representing a quantity of an NMS stock with a market value of at least $200,000 that are communicated only to those who are reasonably believed to represent current contra-side trading interest of at least $200,000. Consequently, IOIs shown to participants in ATSs that cater exclusively to institutions engaged in block trading would not trigger quote obligations. The Commission's reasoning is that these block crossing networks offer significant size discovery benefits (e.g., finding contra-side trading interest while minimizing market footprint) which would be lost if the underlying interest was required to become part of the public quote stream. The SEC's proposed exemption, however, does not mirror the definition of "block size" in Rule 600(b)(9) of Regulation NMS, which also covers orders of at least 10,000 shares without regard to dollar value. In this regard, the Commission stated that it does not believe an exemption for an order for 10,000 shares of a low-priced stock would be appropriate - in its view, the proposed size discovery exclusion should be limited to "truly large size orders." In practical terms, if these amendments are adopted, an ATS utilizing actionable IOIs to inform various market participants of the availability of liquidity within its system would be required to display the orders upon which those IOIs are based as quotes in the public quote stream, or go fully dark. For various reasons, ATSs that derivatively price their executions from the NBBO (e.g., midpoint crossing networks) would not be able to publish actual quotations reflecting orders residing within the system, and therefore those ATSs could have no choice but to go completely dark if they choose to retain their derivative pricing models. The Commission seeks comment on this proposal, including on whether there should be an explicit definition of "actionable IOI," whether actionable IOIs offer significant benefits for market participants that could not be realized if they were subject to public display, and whether the proposed size discovery exclusion is appropriately crafted to protect valuable size discovery benefits without inappropriately excluding valuable size and price information about existing trading interest from the public markets. The Commission also is proposing to lower substantially the trading volume threshold in Regulation ATS that triggers the public display requirement for orders and actionable IOIs shown to more than one person by an ATS. Currently, Rule 301(b)(3) of Regulation ATS requires an ATS that displays orders to more than one person and that has 5% or more of the average daily trading volume ("ADTV") of any NMS stock for four of the preceding six calendar months to display those orders in the public quote stream and to provide execution access to those orders. This threshold is determined on a security-by-security basis, and ADTV is based on volumes reported by an effective transaction reporting plan (e.g., the consolidated tape). The Commission has proposed to lower this threshold from 5% to 0.25% of the ADTV of any NMS stock, and it believes that lowering the threshold to this level will reduce the potential for two-tiered markets and improve the quality of quotation data made available to the public. In its view, this amendment will create a more level playing field with respect to order display and execution access for all market participants that receive and attempt to execute orders, including exchanges, ATSs and OTC market makers.2 In addition, the Commission is proposing to change the language of Rule 301(b)(3)(ii) to make clear that ATS orders and actionable IOIs that are displayed to more than one person, whether inside or outside of the ATS, are subject to the display obligation. Current rule 301(b)(3)(i)(A) of Regulation ATS provides that an ATS will be subject to the display and execution access requirements of the Regulation if the ATS displays subscriber orders to any person other than employees of the ATS, but Rule 301(b)(3)(ii) requires the ATS to include in the public quote stream its best bids and offers which have been displayed to more than one person in the alternative trading system. According to the Commission, technological advances have permitted ATSs to send IOIs to large numbers of non-subscribers that may not have fallen within the exact language of the current rule. Eliminating this distinction between subscribers and non-subscribers for purposes of the order display requirement is intended to prevent the creation of a two-tiered market. The Commission makes clear, however, that ATS employee access to subscriber order information within the ATS alone will not trigger the display requirement. Finally, the Commission proposes to amend Rule 301(b)(3)(ii) of Regulation ATS to exclude from the order display requirements of Regulation ATS orders having a market value of $200,000 or more that are displayed only to those who are reasonably believed to represent current contra-side trading interest of at least $200,000. This is intended to make this rule consistent with the proposed exclusion for similar large-sized orders from the definitions or bid or offer for the purpose of Regulation NMS's quoting obligations, discussed above. The Commission seeks comment on a large number of topics in connection with these proposed amendments, including whether a threshold of 0.25% is an appropriate one, whether the threshold should be based on some criteria other than just dollar value of a trade, whether reducing the volume threshold will promote price transparency and price discovery in the national market system, whether the exclusion for large-size orders is necessary, and whether ATSs should be permitted to display orders only to subscribers without also having to display those orders publicly. Comment is also sought on the broader effects of these amendments on the business of ATSs, including whether subscribers will change how they use ATSs, whether trading costs for institutional investors will increase, and whether these amendments will cause ATSs to go completely dark to avoid public display of their institutional subscribers' orders. The Commission also is proposing to amend the joint-industry plans for the public dissemination of consolidated trade data to require real-time disclosure of the identity of dark pools and other ATSs on the reports of their executed trades. Currently, trades executed in ATSs are reported to the consolidated tape streams through one of the trade reporting facilities ("TRFs") operated by FINRA on behalf of exchanges or through FINRA's Alternative Display Facility ("ADF"). Published trade reports for these trades identify them only as OTC trades, and they do not identify the particular ATS or the broker-dealer sponsor of the ATS, unlike trade reports for executions on exchanges, which do specify the execution venue. Because market share volume on exchanges has declined over the last several years, and market share volume on ATSs and in the OTC markets has increased significantly, the Commission believes that the lack of information concerning the ATS on which trades are executed makes it difficult, if not impossible, for the public to assess ATS trading in real-time, and to identify reliably the execution volume of particular stocks on individual ATSs. Furthermore, the SEC believes that requiring ATS trades to be reported with attribution should enable broker-dealers and their customers to find liquidity more effectively and achieve best execution in the OTC market.3 In its view, "the resulting improved transparency should help ensure that publicly available prices fully reflect overall supply and demand, equip the investing public with tools to make better investment decisions, increase the perception of fairness that is necessary for the healthy functioning of the national market system, and as a result, enhance public confidence in the securities markets." The Commission also proposes to exclude from the ATS attribution requirement trade reports of large size trades (i.e., those with a value of $200,000 or more). In proposing this exclusion, the Commission stated that it is sensitive to the need of investors executing large size trades to control the information flow concerning their transactions, and that requiring such large size trades to be reported with attribution on a real-time basis could cause "undue information leakage" about that trading. As an example, the Commission notes that identification in a large size trade report of an ATS that focuses on large block trading could signal to the market that the entity trading in large size may plan to execute more trades in the same securities, with the risk that other market participants may attempt to take advantage of this information to the detriment of that entity. It should be noted, however, that these large size trades would still be reported to a FINRA TRF or ADF and would appear on the consolidated tape as OTC trades. The Commission seeks comment on the proposed amendments to the joint-industry plans, including whether there are other means of improving ATS post-trade transparency that should be considered, whether the timing and level of detail of ATS-attributed trade reports should be different from that proposed (e.g., would summary end-of-day reports be preferable to real-time, trade-by-trade reports), and whether the large size trade exclusion is appropriate. This is the second of a series of proposals the SEC has announced relating to "dark" trading interest (that is, trading interest that is not included in the consolidated public quotation data) that it believes may be detrimental to the fairness and efficiency of the national market system. Currently pending is the Commission's proposal to ban so-called "flash orders,"4 and the Commission has indicated that it is developing further initiatives in this area and is reviewing other related market structure issues, including direct market access, high frequency trading and co-location. For questions regarding the topics addressed in this Update, please contact any of the attorneys in Schiff Hardin's Securities and Futures Regulation Group. 1Because all market centers are required to provide executions at or within the NBBO, and most if not all market centers, including many dark pools, only give round-lot executions, it appears that almost all IOIs from dark pools would meet the third and fourth prongs of this "actionability" test. 2Interestingly, however, an OTC market maker is not required to display its best bids and offers unless it has 1% of the ADTV of an NMS stock in the most recent calendar quarter. There is no discussion in the release concerning this difference. 3It should be noted, however, that trade reports only reflect trades that have already occurred and do not necessarily reflect currently available liquidity. 4See Schiff Hardin LLP Securities and Futures Regulation Group Update: SEC Action on Flash Orders ABOUT SCHIFF HARDIN LLP Schiff Hardin is proud to have nationally recognized expertise in the regulation of securities and commodity exchanges and markets and the professional participants in those markets. For more information, contact us.
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