November 16, 2009

On November 13, 2009, the SEC continued its review of equity market structures with a rules release proposing amendments to Exchange Act rules relating to non-public trading in National Market System stocks, including trading that occurs in so-called “dark pools.” The SEC is concerned that non-public trading (ie trading that does not occur on a national securities exchange like the NYSE) has the propensity to create a two-tiered system, to the detriment of those who cannot trade non-publicly. At the center of this rules initiative are "dark pools" where traders can anonymously look to buy or sell large blocks of stock in alternative trading systems (or ATSs) by coyly signalling other ATS participants with "indications of interest" (or IOI). The goal is simple, minimize the market impact of a large transaction by limiting information on the participant and the trade. But is it fair that (i) a large investor with access to an ATS can sell 1,000,000 shares of Inc. without driving down the value of his shares while individual investors publicly trading those same shares would be punished by the laws of supply and demand (especially if non-public trades were simultaneously sucking liquidity from the public-market) or (ii) that dark pool participants can treat information sharing as a one way street, using the prices displayed in publicly displayed markets without supplying pricing information of their own? Then again, isn't it preferable that a large trade can occur without sending out confusing signals about the relative worth of Inc.'s stock?

The SEC's proposed rules release notes that "the proposals are intended to promote the Exchange Act goals of transparency, fairness, and efficiency." As you will probably note, however, the proposed rules deal principally with transparency. Are the more subjective issues of fairness and efficiency derivative of transparency? Or are we a long way from finished on this?

The proposed rules have three main components which include (subject to some significant exceptions for block-size quotes or trades):

• Defining “bid” or “offer” in Exchange Act quoting requirements such that they will include actionable IOIs, ie treating them like quotes.
• Reducing (from 5% to 0.25%) the trading volume threshold that would trigger an ATS's obligation to publicly display its best-priced order.
• Requiring real-time disclosure of the identity of each ATS that executes a trade.