Views on improving the integrity of global capital markets
11 February 2016

Is the Sun Rising on Dark Pools? The SEC Wades into the Shadows

Barclays and Credit Suisse settled with US regulators in late January, agreeing to pay a joint $154.3 million for fraudulent dark-pool activities. Barclays admitted to misrepresenting to clients how its monitoring of high-speed predatory trading operated, while Credit Suisse, who did not admit to wrongdoing, was found to have prioritized its own dark pool over others.

Stories like these will be a thing of the past if the US Securities and Exchange Commission (SEC) has its way. A consultation on expanded disclosure requirements for Alternative Trading Systems (ATSs), which include dark pools, is closing on 26 February. The SEC proposal aims to improve the transparency of trading venues operating under the existing Regulation ATS.

Reg. ATS Today

When adopted in 1998, Regulation ATS was designed to ensure basic investor protections in a time of mushrooming off-exchange trading platforms. Regulation ATS allows a trading venue to operate in an alternative and less-restrictive regime to the traditional ‘stock exchange’ regime defined in the Exchange Act. Specifically, an organization that complies with Regulation ATS is exempt from certain exchange requirements such as nondiscriminatory access and nondiscretionary trade execution.

As part of Regulation ATS, Rule 301(b)(2) requires the filing be done with the Securities and Exchange Commission Form ATS at least 20 days before commencing operations, although Form ATS is not approved by the Commission. The information in Form ATS includes:

  • Types of subscribers
  • Differences in services offered to different groups of subscribers
  • Securities to be traded on the ATS
  • Any entity other than the ATS that is involved in its operations
  • The manner in which the system operates including procedures relating to order entry and execution, trade reporting, and clearance and settlement of trades
  • How subscribers access the system

Form ATS is confidential upon filing, and ATSs are not required to publicly disclose such information to market participants. This lack of transparency appears to have allowed some dark pools to operate against the best interests of their clients.

Reg. ATS of Tomorrow

Since Regulation ATS was introduced, there has been significant growth in the number of nonexchange venues trading National Market System (NMS)  stocks as well as trading volume executed on these ATSs. The SEC consultation reports that in the second quarter of 2015 there were 38 ATSs accounting for 59 billion shares traded (15% of total NMS stocks traded). Further, the complexity of these NMS Stock ATSs has increased and their operations are increasingly linked to the operations of their broker-dealer operator.

There is a concern that the lower standards for disclosure and transparency for ATSs, compared to exchanges, may be damaging to market participants by reducing their ability to accurately select and monitor the service provided by ATSs. In particular, recent cases of damaging conflicts of interests between the broker-dealer operator of the ATS and its affiliates and their customers have further put the spotlight on the issue of ATS transparency.

What Proposed Reg. ATS Entails: New Rule, New Form

The SEC has proposed a series of amendments to Regulation ATS. A new rule, Rule 304, would be included that would require the ATS to file Form ATS-N (in lieu of the now abandoned Form ATS) and wait until that form is declared satisfactory by the SEC before being able to operate under an exemption from exchange status under rule 3a1-1(a)(2) of the Exchange Act.

Form ATS-N requires public (as opposed to the confidential Form ATS) disclosure of the activities of the broker-dealer operator and its affiliates in regard to the ATS, including:

  • Any nonATS or other NMS Stock ATS trading venues they operate
  • The products and services offered to subscribers
  • Arrangements with unaffiliated trading venues
  • Trading activity of the broker-dealer operator on its own ATS
  • Use of smart order routers
  • Shared employees of the ATS and any third parties involved with operating the ATS
  • Any differences in the services, functionalities, or procedures available to subscribers and the broker-dealer operator

Existing ATSs would need to reapply for exemption by submitting a Form ATS-N. Unlike prospective ATSs, which would not be permitted to operate until their Form ATS-N is declared effective, existing ATSs would be allowed to operate under the legacy arrangements for a limited period until their Form ATS-N submission is declared effective by the SEC. In either case, if the SEC declares a Form ATS-N ineffective, the ATS would be prohibited from operating as an NMS Stock ATS under the exchange exemption.

Our Take

CFA Institute will shortly submit its response to this consultation and, in general, we agree with the proposed changes. CFA Institute is supportive of any reasonable efforts to promote transparency because we believe this will enable investors to look out for their own interests and protect themselves from damaging conflicts of interest. In turn, this should improve market fairness and integrity, which we believe are critical to the proper functioning of capital markets.

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About the Author(s)
Sviatoslav Rosov, PhD, CFA

Sviatoslav Rosov, PhD, CFA, is Director, Capital Markets Policy EMEA at CFA Institute. He is responsible for developing research projects, policy papers, articles, and regulatory consultations that advance CFA Institute policy positions, focusing on market structure and wider financial market integrity issues.

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