10/6/2009 Cover Story: End of the Line?

SEC Tar…

Cover Story: End of the Line? SEC

Targets Dark Pools and Off-Board
Trading
Traders Magazine, September 2009

Nina Mehta
Has the era of the dark pool come to an end? The Securities and Exchange Commission, spurred on by concern
about two-tiered markets as well as criticism that it is not doing enough to level the playing field for ordinary
investors, is expected to propose new rules this fall that could reduce the amount of trading done away from the
public markets.

Sources tell Traders Magazine they believe the SEC will issue both an outright
rule proposal as well as a "concept release" outlining possible changes to the
way broker-dealers operate their dark pools. The SEC's concern is that too
much volume is being done away from exchanges and electronic
communication networks, and within the four walls of individual broker-dealers.
That could hurt price discovery. In addition, allowing that to happen is seen, by
some, as bad public policy because it short-changes those traders placing
limit orders in the public markets and could hamper investors seeking the best
available prices.

ADVERTISEMENT Currently, about

22 percent of all
share volume is
done off-board,
including
volume Mary Schapiro, SEC
executed in dark
pools. Whether
that figure is too high for the SEC is not known. Any
new rule proposal or concept release is likely to kick
off a debate about how much volume, and what kind
of volume, can acceptably be done away from the
displayed markets without impacting price discovery.

"The jury is out--very much, I think--on dark pools,"

SEC Chairman Mary Schapiro said on CNBC last
month. "That's part of the analysis we're going through now and we'll seek public comment broadly."

Schapiro isn't pulling any punches. In a June speech, she laid out one of the SEC's big concerns: that the "lack of
transparency" about where dark pool executions are occurring could "undermine public confidence in the equity
markets, particularly if the volume of trading activity in dark pools increases substantially." She also highlighted the
"danger that significant private markets may develop that exclude public investors."

What's now on the table is nothing short of a reassessment of key elements in Regulations ATS and NMS. The two
biggest changes being considered are a decrease in the 5 percent volume threshold for display obligations and fair
access for dark pools, and adjustments to the trade-through rule.

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So exactly what might the SEC do? Imagine this scenario unfolding over the course of the next year: The SEC drops
the threshold for dark pools to publicly display quotes and provide fair access from 5 percent to, say, 1 or 2 percent.
It redefines dark pools, knocking out of commission those that are pure internalization engines for market makers.
Automated indications of interest that zip around between dark pools and from dark pools to trading centers or other
venues must be publicly quoted if the ATS triggers display requirements. All dark pools must count executions the
same way and reveal more information about their trading activity after a suitable time delay, enabling broker-
dealers to know how much of the market in particular securities is trading in particular ATSs.

And finally, to continue the speculation, the trade-through rule gets a major tune-up that prevents dark pools (and
possibly upstairs desks) from trading at the market's best price by simply matching that price. Instead, those pools
would be required to take out the available displayed liquidity at the national best bid or offer before trading at that
price. The SEC declined to comment for this article.

The scope of what the SEC is considering is radical. Robert Greifeld, CEO of Nasdaq OMX Group, has referred to
the prospect of change as "Reg NMS 2." He told analysts last month: "As we go into a period of time where there'll
be renewed market structure discussions--it'll be Reg NMS 2--we have to make sure we take a comprehensive look
at what's transpiring in the markets."

Greifeld himself isn't above stoking the fires. In a July letter to SEC Chairman Schapiro, Greifeld said his company
"is concerned that the securities industry appears willing to accept more and more 'darkness' and limits on the
availability of order information." He added that the goal should be "to eliminate any order types or market structure
policies that do not contribute to public price formation and market transparency." He then laid out his wish list: "This
would include not only flash orders, but the increasing use of 'dark pools,' internalization, and other venues in which
the public is not permitted to participate fully."

Nasdaq isn't the only exchange pushing the SEC to reconsider existing
rules. In June, Thomas Callahan, a NYSE Euronext executive vice president
and head of the exchange operator's futures business, asked Congress to
pressure the SEC to reexamine its regulatory regime for alternative trading
systems. "Through so-called 'dark pools,' ATS operators have been allowed
to create private markets for securities transactions," Callahan said in
testimony before the House Financial Services Committee. He added that
disparities in the regulation of exchanges and ATSs have hurt exchanges.

Lawrence Leibowitz, head of U.S. execution and global technology at NYSE

Euronext, laid the ground for those comments in a May speech when he
said, "I think it's a good time...to just revisit ATS and order-handling
practices." He noted that while the equities markets held up extremely well
throughout the financial crisis, "Our market structure has gone astray."

For exchanges, any rule-making that curtails off-board trading, and limits
the ability of broker-dealers to internalize order flow through dark pools, is Robert Greifeld, Nasdaq OMX Group

likely to benefit their markets. "Some level of liquidity is necessary for

healthy price formation and a robust displayed limit market, said Joe Ratterman, CEO of BATS Global Markets,
which operates BATS Exchange. "The SEC doesn't want information to get opaque again, transparency to disappear
and have everybody trading in their secret little corners." He doesn't, however, think the SEC should constrain off-
board trading through new rules.

A former regulator has also expressed concern about the current market structure. Richard Lindsey, who ran the
SEC's Division of Market Regulation (now called the Division of Trading and Markets) from 1995 to 1999, suggests
that the two-tiered markets that led to the Order Handling Rules in 1996 are now being replicated via the presence of
automated non-displayed liquidity. "In the old Nasdaq market," he said, "one way that quotes got wider in the public
market was that there was a vehicle for trading to take place that the public market didn't see--which was Instinet at
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market was that there was a vehicle for trading to take place that the public market didn't see--which was Instinet at
the time." He added that Instinet did not know how its market was affecting the public market.

"Dark pools are nothing more than turning the screen off in [a modern] Instinet, because people know there are
quotes there," Lindsey said. "And flash orders take it one step further because the market center actually shows the
quote to people, but just not everybody." In his view, this type of activity has the potential to keep spreads in the
market wider than necessary, even though spreads are at historically low levels. Lindsey is president of consulting
firm Callcott Group.

Reg DARK
The operator of one dark pool is mixed about how much new regulation is necessary. "We think there are order-
routing practices and other gaps that need to be closed," said Greg Tusar, head of U.S. electronic trading at
Goldman Sachs Execution & Clearing. "But the market is as competitive as it's ever been, spreads are narrow, and
transaction costs broadly have been in decline for years. That's benefited retail and institutional investors alike." He
stressed that Goldman Sachs "doesn't believe that a massive reform is necessary and we'd caution against that."

Andrew Silverman, co-head of electronic trading at Morgan Stanley, acknowledges that dark pools may see their
share of the market shrink if the SEC issues a "Reg DARK," as he put it. "Some possible regulations that are being
debated may disadvantage the growth of dark pools," he said. "But we support transparency about order-routing
practices and regulation that promotes the health of the public quote."

The era of dark pools began in 1986 when Instinet offered the first after-hours crossing platform. The next year, ITG
created POSIT, which operated intraday (ITG was then a subsidiary of Jefferies). There are now two broad types of
dark pools operated by broker-dealers: the classic large-order crossing platforms run by ITG, Pipeline Trading
Systems and Liquidnet, and the mostly small-execution-size pools run by bulge-bracket firms. This latter group
seeks to cross customer flow or enable internal desks or other liquidity providers to trade against that flow at the
market's best price. A lot of traditional buyside flow comes to these pools through algorithms. Trades of the large-
order variety typically go off at the midpoint of the national best bid and offer, while executions in big brokers' pools
are often done at the best bid or offer, particularly for high-volume, penny-wide stocks. It is these pools that are likely
to suffer the most if the harsher of any new rules come to pass.

Hello 1%
In one of its bigger potential moves involving dark pools, the SEC is now
looking at the threshold at which non-displayed ATSs must display their
quotes and provide fair access to their liquidity to the public. Currently, the
threshold is 5 percent. In most cases, if a dark pool transacts 5 percent of the
average daily volume in a security in four of the last six months, it cannot trade
in that name without displaying quotes in that security publicly and providing
broad access to its pool.

The 5 percent threshold, according to industry sources at broker-dealers and

elsewhere, could be pared down to 1 or 2 percent. Others say 2.5 percent is
more likely. That could happen in rule-making this year, or it could be part of a
concept release that would kick the decision down the road.

Dropping the threshold to 1 percent would affect executions in many pools.

Credit Suisse's CrossFinder, Goldman Sachs' Sigma X and Getco Execution Thomas Callahan, NYSE Euronext
Services are the only ATSs publishing volume figures that had more than 1
percent of consolidated volume in the last several months, according to Rosenblatt Securities. In individual
securities, however, those ATSs as well as many others could easily account for a much higher share of
consolidated volume.

Orders in dark pools typically sit and wait for executions. However, some pools send out messages to other venues
to rustle up contra-side liquidity. There has been uncertainty in the industry for a couple of years about whether these
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to rustle up contra-side liquidity. There has been uncertainty in the industry for a couple of years about whether these
automated IOIs and other messages are actually quotes. That uncertainty is ending. James Brigagliano, co-acting
director of the SEC's Division of Trading and Markets, has described IOIs that can be immediately hit or lifted as
"actionable order messages" and has suggested that more specificity on this subject is coming this fall. Actionable
order messages would have to be publicly quoted if a dark pool hits the ATS display threshold.

Dark pools, of course, are built around the assumption that order flow won't be displayed, since doing so would
expose the intentions of participants. Even if dark pools are executing small-size flow, displaying that information
could cause customers to yank their orders and redirect them elsewhere. Trying to avoid triggering the display
requirements would mean less liquidity and therefore less growth for dark pools.

For regulators, another dark pool concern involves order-handling issues for broker-dealers. "The most immediate
focus [for the SEC] is probably whether dark pools are out of compliance with Reg ATS," said Jamie Selway,
managing director of institutional broker White Cap Trading. "That includes how people are using IOIs and whether
market makers are meeting their display obligations if they're trading at better prices in dark pools that send out IOIs
than what they've displayed in public markets [under their own name]."

Lindsey, the former SEC regulator, thinks that lowering the threshold is a good idea. "Reg ATS was meant to allow
new technologies to be developed, not for people to fly under the radar," he said. "So lowering the threshold would
make sense from that standpoint."

Many broker-dealers might not be affected by a lower Reg ATS threshold for display and fair access, and probably
wouldn't object to the change. "We wouldn't necessarily have a problem with the SEC touching the fair-access
threshold," said Jonathan Kellner, president for North America at institutional broker Instinet. "But I hope it would be
done after a thorough analysis." Instinet operates two intraday dark pools.

Trading At the NBBO

At a market structure conference sponsored by the Securities Industry and Financial Markets Association in May,
David Shillman, an associate director in the SEC's Division of Trading and Markets, observed that the Commission
is now looking at a range of issues regarding off-board trading. "From a policy perspective, we are looking at
whether we should take further steps to encourage displayed liquidity and see if dark interest is subverting the price
discovery process," he said. "We would include both traditional market-maker internalization and dark pool activity in
that analysis."

Shillman went on to raise the possibility of altering the trade-through rule in Reg NMS to encourage the display of
more limit orders. He said the SEC may consider a prohibition on trading at the national best bid or offer unless the
price-setting interest is first executed.

Turning the trade-through prohibition into a "trade-at" prohibition would encourage more competition between
orders, which aids price discovery. Right now, firms can match the NBBO and execute at that price level without
having to execute against displayed liquidity. The ability to "quote-match" enables dark pools, upstairs desks and
wholesalers to execute at the best price by simply matching that price. A trade-at prohibition would require firms to
execute the liquidity available at the NBBO first, before trading at that price. If they didn't want to do that, broker-
dealers could offer customers price improvement.

A prohibition on trading at the NBBO would cause dark pool volume to capsize. "The SEC has talked about the
possibility that maybe dark pools shouldn't be allowed to match the price displayed in the displayed markets," White
Cap's Selway said. "That would be a big change, since it would hold dark pools to higher standards, and possibly
end the practice of dealer internalization via dark pool." Selway, however, thinks a trade-at prohibition is unlikely,
especially if current industry discussions turn into a bigger debate about the value of internalization.

Dan Mathisson, head of the Advanced Execution Services group at Credit Suisse, also doesn't think a trade-at rule
will come to pass. If it did, he said, both institutional and retail traders would suffer. Institutions would incur more
market impact costs by having to trade much more in displayed markets, while retail clients would pay higher
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commissions.

Mathisson pointed out that "trading is currently a revenue source for retail brokers that sell their order flow [to
wholesalers and other broker-dealers], allowing them to charge low commissions." That practice is known as
payment for order flow. A trade-at prohibition would prevent wholesalers from internalizing flow at the market's best
price, either forcing them to provide more price improvement or forcing retail brokers to pay the same execution fees
as everyone else. If that change to Reg NMS goes through, Mathisson observed, "Say good-bye to $5 commissions
for Uncle Bob in Michigan."

Other industry executives are more open to the idea of a trade-at prohibition. "It's bad market structure to preference
dark liquidity that doesn't improve on the spread," said Kim Bang, CEO of Bloomberg Tradebook, an ECN and
broker-dealer. "In my opinion, we should prioritize those investors who choose to display their interest."

In the ATS world, a trade-at prohibition wouldn't be likely to hurt the biggest crossing systems, or indeed all small-
execution-size dark pools. Pipeline and ITG's POSIT already execute all orders at the NBBO midpoint. Liquidnet's
primary ATS allows negotiation, but more than 86 percent of that volume is done at the midpoint. Large customers,
seeking to minimize market-impact costs, have gravitated to midpoint executions to avoid revealing their interest on
the buy or sell side.

Ratterman of BATS, however, doesn't like the idea of a trade-at prohibition for dark pools, even though dark pools
siphon off liquidity from the displayed markets. "That uses a big fat sledgehammer of regulation to make it look like
you can operate a dark book, [while] really making it, regulation-wise, so painful you stop trying," he said. "I think that
limits functionality." He'd rather investors have more choice.

Cover Sidebar: What Do They Think?

As the debate about dark liquidity takes off, experts on market structure are weighing in with their views on what's
necessary. Here are some highlights.

William O'Brien, CEO of Direct Edge, an ECN, stresses that displayed and non-displayed, as well as exchange and
non-exchange, liquidity have long managed to exist together in ways that benefit investors. "There may be a need to
adapt regulations to new technologies," he said, "but that doesn't mean a re-architecting because of fundamental
unfairness." He suggested that the way non-displayed orders now get worked in the market has "simply moved from
sales traders shopping orders around on the phone to doing it on a server in an automated way."

Larry Tabb, founder of research firm TABB Group, points out that the current market structure debates are occurring
against the backdrop of an extremely fragmented market in which liquidity is hard to find. He doesn't think that
limiting the ability of institutions to execute in the dark is a good idea. "The harder it is for institutions to get trades
done in this marketplace of decimals and high-frequency trading, and machines trading against machines, the
more people will hide their order flow until the overall economics change," he said. "When 500 shares becomes a
big order, people just won't display 500 shares."

In his view, the SEC hasn't hit on the right incentives to display liquidity. "The last thing the SEC wants to do is open
up a two-year debate on market structure," Tabb said. "But right now everything is fair game to be re-regulated."

Kim Bang, president of Bloomberg Tradebook, a broker-dealer and ECN, agrees that the hunt for size and off-board
liquidity is the result of changes brought about, most immediately, by Reg NMS. "If the SEC analyzes how brokers
and venues interact, and why brokers internalize flow through dark pools, they shouldn't ignore access fees," he
said. At the same time, he speculated that the SEC may "want to do the minimal amount of surgery to change the
current market structure, since the markets are functioning remarkably well."

--N.M.

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