Transparency could guide SEC trading agenda

Increasing the transparency of prices and potential conflicts of interest in institutional trades in dark pools and automated trading systems will drive the SEC's policy agenda for the next several years and could offer investors leverage to better control trading costs.

SEC Chairwoman Mary Jo White, in a speech earlier this month, said the regulatory agency would consider requiring more disclosure of institutional trades made through dark pools and other automated trading systems, and require high-frequency traders to register as broker-dealers.

“We must continue to examine whether dark trading volume is approaching a level that risks seriously undermining the quality of price discovery provided by lit venues,” Ms. White said at a Sandler O'Neill + Partners conference in New York.

Executives from exchange operators and fund companies also are starting to join in warning that the market is beset with conflicts that can harm investors and undermine confidence. Support for a solution increased at a June 17 hearing of the Senate's Permanent Subcommittee on Investigations.

Ms. White, in her speech, “came out with one of the most sweeping policy discussions of what the SEC wanted to do on market structure,” said Robert Hegarty, managing director, global head of market structure, Thomson Reuters, Boston. “In that speech, she set policy for the next three to five years.”

Justin Schack, partner and managing director, Rosenblatt Securities Inc., New York, said: “Twenty years ago, there were two main U.S. exchanges (New York Stock Exchange and Nasdaq) while today a NYSE-listed stock can be traded on 11 different stock exchanges and 25 different dark pools.

“The number of venues creates a lot of opportunity for brokers to trade in a way that's advantageous to them and not so much for the investor,” Mr. Schack said.

Some fear that SEC rule changes could hurt pension funds, endowments, foundations and money managers that use dark pools to trade large blocks of stocks. The value of their traded shares could fall if off-exchange venues were required to disclose both pre- and post-trade information, which could tip the overall market to such large trades. However, several researchers who advise on capital markets say the SEC most likely is focusing on post-trade disclosure. They also believe that, in light of publicity on high-frequency trading since the release in March of Michael Lewis' book, “Flash Boys,” the SEC is targeting overall disclosure in trading and not picking on dark pools.

Among the possible rules the SEC could create, sources said: Dark pools and automated trading systems could be required to provide delayed disclosure of trades similar to what the Commodity Futures Trading Commission requires for derivative or swap trades and what the trade reporting and compliance engine developed by the Financial Industry Regulatory Authority mandates for over-the-counter bond trades. Both require disclosure 15 minutes after a trade.

Without taking disclosure delays into account in creating regulation, “dark pools would have to find some way to make those (trade) matches,” said Kevin McPartland, principal and head of market structure research at Greenwich Associates, Stamford, Conn. “Regulators need to think about that. You don't want to create rules that would mean they would have to make a workaround. You want the markets to work.”

“Too much transparency is not always a good thing in trading,” said Mr. McPartland. “The information leakage would be such that no one would want to execute large trades. There inevitably would be an impact, but more on the cost of the information leakage, because the price of those shares would go down as the market sees how much is being traded, and acts. Also, though commissions wouldn't change, the algorithms needed to divert trades to several venues would become more expensive.”

Rosenblatt's Mr. Schack added: “I get the impression (potential SEC rules) are directed at after-the-fact transparency, not ... changing dark markets to lit markets. That would be a big change.”

He believes post-trade disclosure would make institutional investors more knowledgeable about how their shares are being traded and if any conflicts of interest emerge with the trading venues their brokers are selecting.

(Some dark pools provide a rebate to brokers when they're used to trade shares.)

Two subjects of Ms. White's speech — trading transparency and broker conflicts of interest — should resonate with asset owners and other investors who trade large blocks of shares, Mr. Hegarty said. “She's trying to bring more transparency to trading not just to improve the process, but to help improve investments,” he said. Trading “really is an alpha source. It's much more difficult to get alpha today. Every basis point counts. Better transparency means better execution and better investing.”

Heightened transparency of dark pools also would reduce the number of such venues, said Sang Lee, managing partner, Aite Group, a consulting firm in Boston. “I think this increase in transparency and reporting requirements will more than likely lead to the loss of those dark pools that are perhaps not engaged in meaningful contribution to overall market quality,” Mr. Lee said in an e-mailed response to questions. “I would say this is probably not a bad thing for the asset owners and also quite positive for the asset managers themselves.

“The original intent of dark pools — or the less menacing name of "non-displayed' pools — was to provide the necessary outlet for buy-side firms to be able to move large sizes (share blocks) without moving the market,” Mr. Lee added. “I think everyone would agree that, along the way, that focus might have been lost. This does not mean that dark pools are not needed, but probably need to be better defined. Providing more legitimacy over the existence of dark pools through more transparency and reporting could lend more credibility to the market and hence increase investor confidence.”

Executives at dark-pool operator Liquidnet Inc., New York, are “big proponent(s) of increasing the transparency of the operational aspects of the business and think other dark pools should do the same,” said Adam Sussman, senior adviser, head of market structure and liquidity partnerships at Liquidnet. “It's industry-positive. Transparency is a disinfectant for negative behavior.”

Liquidnet already discloses to its clients the types of liquidity sources on its system and allows clients to opt-in to each, including to specific brokers. Mr. Sussman said the firm encourages other dark pool operators to do the same.

Liquidnet on June 6 reached a $2 million settlement with the SEC over charges that it used subscribers' confidential information to market its services. The company neither admitted nor denied any wrongdoing.

The potential regulatory changes are “unlikely to have any dramatic effect on our trading,” said Dennis MacKee, spokesman for $180.3 billion Florida State Board of Administration, Tallahassee, which trades on dark pools. “It is unlikely that this will be a "game changer' for us, although keep in mind we don't have a lot of details at this point.”

Thomson Reuters' Mr. Hegarty said Ms. White's remarks are following the overall regulatory strategy in place since the financial crisis in 2008-2009, with a focus on bringing transparency to the markets. And recent moves by the Financial Industry Regulatory Authority, Washington, and some dark pool operators to disclose delayed trading volumes are following that trend.

Added Rosenblatt Securities' Mr. Schack: “The requests for more information (by pension fund investment executives and non-trading staff) have definitely increased in the past few years, but those requests have been supercharged since "Flash Boys' came out. The requests for us to talk with clients about this have increased exponentially since then.”

At the Senate subcommittee hearing last week, representatives from New York Stock Exchange owner Intercontinental Exchange Inc., IEX Group Inc. and Vanguard Group Inc. said trading rebates and payments to brokers for investor trades warrant greater government scrutiny. The systems, embedded over the past two decades, were cited among the reasons high-frequency firms now account for about half of volume. The hearing focused on potential conflicts of interest among brokers and mostly steered clear of high- frequency traders.

“Hopefully the regulatory agencies are going to take action,” Sen. Carl Levin, D-Mich., chairman of the subcommittee, said at the end of the hearing. “There are steps which must be taken either by regulators or by Congress to deal with conflicts and to deal with the other kinds of problems which exist in the current market, because it's clear there can be improvements.” n

Bloomberg contributed to this story.