Are dark pools still dark?
If one thinks back to what a dark pool or Alternative Trading System (ATS) was a few years back, they were indeed dark. Most traders didnt know what exactly went on inside them except that when these liquidity centers worked orders got filled. Block orders. Neither who filled a buy or sell order wasnt known nor how the order was filled. The participants that lurked inside these pools were unobserved and left to their own devices and for the most part, they worked.
But then the public or lit exchanges like Nasdaq, Direct Edge and NYSE saw their trading volumes fall (and profits) as institutional order flow switched from their marketplaces to the dark. And they complained. Loudly. Arguing that these pools functioned without regulations that they themselves werent subject to and how the retail investor was being hurt by this new undisplayed liquidity, the regulators got involved.
Regulators wanted to know more about these dark pools – who was in them, trade size, timing, etc. Dark pools countered that to give up this information would hurt the buy-sider who traded within it as it would lead to leakage and inferior execution quality. At their first attempt, the regulators failed to get much information or cooperation from the dark pools.
But that all changed on their second attempt. FINRA made dark pools and other ATS report their trading activities in June 2014. This was their statement:
As part of the Financial Industry Regulatory Authority (FINRA)’s effort to increase market transparency and thereby enhance investor confidence, FINRA today began providing data indicating the activity levels in each alternative trading system (ATS), including all market facilities commonly called “dark pools.” This important information will shed light on the securities that are traded in each “dark pool,” which occurs away from traditional stock exchanges. While the trades in these facilities are made available on a real-time basis to investors and professionals today through securities information processors (SIPs), these trades are not attributed to a specific ATS or “dark pool.
Under FINRA’s new transparency initiative, the public will now be able to see the total shares traded each week by security in each ATS or “dark pool.” This data will be provided to the non-professional investing public free of charge and is available through FINRA’s website. ATSs account for a significant percentage of total OTC trading in exchange-listed equities in the United States. Currently over 30 percent of the total National Market System volume of shares traded occurs over the counter.
FINRA hopes that providing a clear view of the level of activity handled by these ATSs or ‘dark pools’ will increase market transparency and thereby enhance investor confidence. FINRA’s commitment to transparency is bringing light to what was previously a dark area of the equity markets. Making this information available to both the investing public and market participants provides an unprecedented view into the activity of these highly significant trading venues,” said Steven Joachim, FINRA Executive Vice President, Transparency Services back in June 2014.
As it stands to date, each ATS is required to report to FINRA its weekly aggregate volume information on a security-by-security basis. FINRA will publish the information regarding Tier 1 NMS stocks (i.e., stocks in the S&P 500 Index, the Russell 1000 Index and certain ETPs) on a two-week delayed basis. Information on all other NMS stocks and OTC equity securities subject to FINRA trade reporting requirements will be released two weeks following the publication of information for the Tier 1 NMS stocks.
So, are dark pools still dark? Yes. And no. While Finras mandate requires some reporting it doesnt require all reporting. And the data is delayed, preserving the buy-sides original needs for block liquidity and anonymity. And the exchanges, who publicly complained about vanishing volumes (and privately falling revenues) learned to offset their lost execution volume and profits and entered the data provision business.
Brian Williamson, Head of Sales at Luminex Trading & Analytics spoke with Traders Magazine and said that as the original article noted, at the time there was a lot of debate about the frequency of reporting, especially in less liquid names.Today, he commented, the market can say that the regulators found a timing sweet spot for both liquid and illiquid names, assuaging many institutions fears about leakage and long-lasting orders.
The reporting facility has been impactful since it has been so data-centric, Williamson said. With dedicated looks at Tier 1, Tier 2 and monthly blocks traded, the buy-side can review and make-well informed routing decisions based on a variety of meaningful factors.
He added that Luminex welcomes greater transparency in the market and think the regulators took a great step toward achieving that goal.
Today, if a firm says they are trading blocks, you can pull the data yourself and see if they are being truthful, he added. Thats essential to building the trust that makes markets work as best as possible for all participants.
Sounds like dtente has been achieved in the battle between dark pools and the exchanges. For now.
The following article originally was published in the October 2013 edition of Traders Magazine
Coming Out of the Dark
By John DAntona Jr.
Same target, different regulator.
In 2009, the Securities and Exchange Commission proposed a package of three rules aimed at operators of alternative trading systems, including dark pools. As part of the “Regulation of Non-Public Trading Interest,” as the proposal was called, the SEC suggested that dark pool operators be required to attach their names to their trade reports.
This post-trade disclosure idea didn’t sit well with many industry participants, primarily because the SEC believed it should be done in real time. Buyside traders and their brokers were concerned that such frequent reporting would result in undue information leakage. The proposal never got beyond the comment period.
Now, four years later, the Financial Industry Regulatory Authority is trying again. Industry sources tell Traders Magazine that a similar proposal is being worked on that would require brokers to report their off-board “dark” trades to FINRA. The exact time a broker or other venue would have to report its trades is still open to discussion, as is just when the regulator would publish the data on its website after it gets it.
A rough draft of the proposal could come as early as this month, sources tell Traders Magazine. (See “Briefs” section for details.)
FINRA spokesman George Smaragdis told Traders Magazine in an email that the regulator expects to file the proposals with the SEC in the near future. He provided no further comment.
Driving the idea for such a rule are exchanges’ and regulators’ concerns that too much trading is taking place off-board in dark pools and brokers internalization engines. That hurts price formation on the public exchanges. FINRA’s disclosure rule is considered a positive first step in achieving an understanding of the extent of dark pool trading.
INTO THE LIGHT
Christopher Nagy, president at KOR Trading and former managing director for order routing and market data strategy and co-head of government relations at TD Ameritrade, told Traders Magazine that FINRA was working with the broker-dealers that run their own dark pools, other alternative trading system operators and the buyside to come up with a reporting system all could work with.
“This regulation will get passed,” Nagy said of the to-be-announced regulation. “The feeling of some operators is this type of mandate to report is OK, but the frequency of said reports needs to be sorted out first.”
Off-board trading accounts for around 35 percent of total volume. But for some stocks, it often runs higher, at 40 percent-or for some, as high as 100 percent. Off-board trading includes four categories: dark pools, internalization, electronic communication networks and broker block trades.
The proposed rule targets dark orders traded off-board. That include broker-dealer and private alternative trading systems, internalizers and wholesaling firms like KCG Holdings, Nagy added. The rule will not impact dark trades done on the exchanges.
WHAT’S THE FREQUENCY?
The main point of contention in the rule proposal, Nagy said, is the frequency and publication of trades. He said this was still being debated at press time.
On the one side are the regulators and the exchanges; both are concerned over the growth in off-board trading and how it hurts public price discovery. On the other side are the brokers and other dark pool operators and the buyside, who claim these less transparent venues allow anonymous trading and better price and size execution away from the unsavory traders found on the public or lit exchanges.
Timing of the reporting of dark pool data, Nagy said, seems to be centering at the once-per-month format. FINRA would be the aggregator of the data and publish it on their website. The dark pools or other ATSs would furnish volume data as most already monitor it and have the data readily available. With FINRA publishing this data, some firms that already provide a glimpse into dark pool activity, such as Rosenblatt Securities, could find themselves competing with the regulator, Nagy added.
“I think it is better to have a regulator publish this data,” Nagy said.
And dark pool operators, big and small, seem to be comfortable with FINRA publishing the data, as long as it doesn’t compromise their mission of providing liquidity and anonymity.
Dan Mathisson, head of U.S. equity trading at Credit Suisse and operator of the largest dark pool, Crossfinder, told Traders Magazine he supports the idea of the FINRA proposal despite not seeing a draft of any rule or the details just yet. Credit Suisse was one of several dark pool operators that self-reported volumes for a time; it stopped in April, due to frustration concerning the lack of uniform reporting criteria among self-reporters.
“Overall, we’re looking forward to it,” Mathisson said of the idea of upcoming FINRA regulation. “It would be healthy for the market for everyone to report volumes and have the same reporting methodology. Consistent reporting criteria are the key. The ad hoc way things were being reported frustrated us.”
Keith Ross, chief executive of PDQ ATS, a Chicago-based alternative trading system, recently told Traders Magazine he too was OK with proposed new rules governing dark pools and initiatives aimed at making them more transparent. Ross said he was in favor of more transparency, as it would bolster investor confidence in the equity markets, something he felt was needed to boost trading volume overall.
“FINRA has proposed each of the ATSs report by issue the amount of stock they trade in a given week,” Ross said, based his knowledge of the proposed rule. “ATSs will have a week to report their data, and then FINRA needs another week to collate this data and then publish any report. There will be a public record of how much volume of stock is trading in a particular venue.”
As a dark pool operator, Ross said it wouldn’t be difficult to respond to this new requirement from FINRA for more data.
WHY THE RUSH?
Robert Felvinci, head trader at Spinnaker Trust in Maine, said he didn’t have an issue with a dark reporting rule, as long it incorporated some type of reporting delay period.
I don’t have an issue with the reporting of trading data, but there should definitely be a delay in the reporting of these trades to protect against high-frequency trade operations in the market that are looking for opportunities to profit from this trading information,” Felvinci said. “Whether that delay is two days or two weeks, I don’t think it matters that much, just as long as there is a delay.”
He added that those who are against any type of delay or who want the data immediately are individuals representing HFT businesses or those who claim to represent the retail investor.
“But what many forget is that the retail investor or ‘little guy’ is whose money an institution actually represents,” Felvinci said. “Whether it is a mutual fund, 401k or pension fund … that is whose money is typically being traded and invested by the institution.”
Those in favor of such as rule, such as Felvinci, are traders simply trying to do their fiduciary responsibility of getting best execution for their clients and avoid getting gamed.
As for the exchanges and internalizers, the early consensus looks to also be in favor of a dark trading proposal.
While spokesmen for Nasdaq OMX and NYSE Euronext both declined to comment, a spokesperson for BATS/Direct Edge did tell Traders Magazine that it supports FINRA’s efforts to provide more information.
“We have always believed in providing transparency wherever appropriate, and we support FINRA’s efforts to try to bring an appropriate level of transparency to trading that happens away from the lit exchanges,” the BATS spokesperson said.
And at least one of the internalizers is OK with a rule proposal. A spokesperson for KCG Holdings, the company formed by the union of Knight Capital and Getco, said the firm supports providing investors with increased transparency around where to source liquidity.
“We look forward to commenting on the proposal when we have the opportunity,” the spokesperson said.
However-despite not having yet seen the proposal-Credit Suisse’s Mathisson said that as he understands it, the proposal doesn’t go far enough in lighting up the dark. While the final rule will govern dark pools and non-public trading, he noted that it doesn’t appear to address the dark liquidity being transacted on the lit exchanges such as NYSE Euronext or Nasdaq OMX. He contends that the exchanges, such as NYSE, operate large dark pools themselves. Among the 150 or so order types offered by today’s exchanges are dozens of dark varieties, as well as order types that switch between lit and dark, such as “Hide and Slide.”
Furthermore, Mathisson argued that exchanges and off-exchange ATSs are more similar than different. They are both for-profit businesses, he said, they both offer dark and lit order types, and they both create pricing plans designed to maximize their profit. As a result, the line between exchange and off-exchange trading is blurrier than it’s ever been.
“While the FINRA rule is good and we’d like to see it, it gets the industry only halfway there in terms of disclosure,” Mathisson said. “I want more disclosure from the exchanges about their dark liquidity. While this proposal sheds light on ATSs, it doesn’t shed light on exchange dark trading. That remains in the shadows.
