Increasing Transparency of Alternative Trading Systems

Kara M. Stein is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Stein’s recent remarks at a recent open meeting of the SEC; the complete publication, including footnotes, is available here. The views expressed in the post are those of Commissioner Stein and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

Today [November 18, 2015], the Commission meets to consider a proposal to increase the transparency of alternative trading systems (ATS). Many ATSs are commonly referred to as “dark pools”. To most people, dark pools are a little bit of a mystery, and that’s because they often function in great secrecy. Today’s proposal seeks to shine a light into that darkness.

Modern ATSs are a product of the rapid technological advances that have revolutionized the way stocks are bought and sold. An ATS is an electronic order matching system operated by a broker-dealer. Much like an exchange, it brings together buyers and sellers. There are many types of ATSs, and they facilitate the purchase and sale of all types of securities ranging from equities to corporate bonds to Treasuries, and more. Unlike an exchange, which must disclose publicly quotes and prices at which securities transactions occur, an ATS can operate in the dark with only limited information about its operations.

Beginning in the 1990s, broker-dealers started using emerging electronic communications networks to reimagine the capital markets. One of the first ATSs was launched in 1996 and competed directly with exchanges through an entirely electronic platform. This platform eliminated both the specialists and the market makers. These trading venues were also a place for larger-sized or “block” trades. Relatively quickly, alternative trading systems started handling a significant amount of securities order volume. Dark pools were in many ways replacing the traditional “upstairs” market, while also providing services conventionally provided only by registered exchanges. And, they had a growing footprint in the capital markets.

Since 1998, ATSs have been governed by Regulation ATS. This 17-year old Commission rule started to integrate these emerging trading systems into the regulatory framework. Reg ATS provided an exemption for these alternative venues from ordinary exchange regulation in order to encourage the development of these new and innovative market centers. In addition, unlike exchanges, ATSs were not required to provide public transparency about their operations or their activities.

These late 1990s regulatory changes did encourage the proliferation of these alternative trading venues. By 2009, the number of active dark pools had grown to 32 and accounted for 8% of the shares traded. Over the past several years, both the number of active dark pools and the percentage of shares traded in dark pools has increased.

Today, the number of active dark pools has increased over 25 percent, and now accounts for over 15% of the total shares traded in U.S. markets. It is currently estimated that over 200 billion shares of NMS stocks are traded on nearly 40 of these private trading venues representing over $10 trillion in securities transactions each year. What was once a niche venue for certain sophisticated parties negotiating large- sized trades is now a significant part of the capital markets.

Moreover, the line between ATSs and exchanges has become much blurrier. These alternative trading systems have grown up and become a major part of the marketplace. The current average trade size of about 200 shares is not significantly different from the average trade size that occurs on exchanges. And the volume of the business done in dark pools has grown so significantly that one must at least consider what, if any, effect it is having on price discovery in the larger marketplace, or perhaps how it could be contributing to a masking of true supply and demand.

Recent enforcement actions by the Commission and others have also highlighted some issues regarding how some ATSs have been functioning.

Today’s proposal seeks to begin to address some of the issues that have emerged during the past 17-years. It relies heavily on the tool of disclosure, proposing to increase the operational transparency of dark pools and their operators. It is an important first step, and one that I support. Greater transparency, the hallmark of the U.S. capital markets, should benefit both issuers and investors.

Under today’s proposal, ATSs would for the first time be required to publicly reveal important information about what they do and how they work. The new form in the proposal, Form ATS-N, requires ATSs to answer some basic questions that should inform investors about the range of operations of the ATS. This includes information about its fees, trading services, use of market data and fair access standards. It also requires ATS operators to describe their smart order router and the algorithms they use to send or receive orders.

In addition, ATSs would be required to disclose any potential conflicts of interest. For example, an operator would need to disclose a potential conflict that might arise from its own dealing activities within the dark pool.

Most important, the proposed rule would require an ATS to publicly report important metrics or performance statistics if they are provided to one or more subscribers. Sometimes this information, such as the characteristics of their order flow or execution, is provided only to certain subscribers so that they can evaluate whether a venue may meet their investment objectives. While the Commission is not prescribing a one-size fits all approach, in this proposal, we are asking about ways to improve the standardization and comparability of such data and reporting across ATSs. I hope market participants and others will help us think through the best practices for disclosure in this area.

While disclosure is absolutely a positive step forward, the question I am left pondering today is whether we have done enough. For example, does the relationship between a broker-dealer operator and its ATS make it more difficult for disclosure to adequately address certain inherent conflicts of interest with its subscribers? Are there certain conflicts of interest that should be addressed in other ways? Should certain conflicts of interest just be prohibited going forward?

Finally, there are important venues that are left out of this ATS transparency proposal. Given the unusually high level of volatility that was experienced in the U.S. Treasury market in October 2014, are there reasons why investors that use alternative trading systems to buy and sell Treasuries, fixed income bonds, or other securities would not benefit from basic disclosures about how these electronic platforms operate or their potential conflicts of interest? Has the Commission missed the mark by creating a new class of NMS Stock ATSs, which will have greater transparency than other alternative trading systems?

Forty years ago, Congress directed the Commission “to remove impediments to and perfect the mechanism of a national market system.” My predecessor, Commissioner Phillip Loomis, described these improvements as “a maximum opportunity for…orders to interact and be matched, and [to enable] market professionals…to have access to the entire order flow and this in turn greatly improves their ability to perform their functions effectively and efficiently.” Have we achieved that objective, or more importantly, the objective of making sure ATSs contribute to fair and orderly markets that promote capital formation while protecting investors?

I look forward to commenters views about whether this is the right approach and how the Commission can better address the fairness and efficiency of ATSs and their role in the larger capital markets.

Thank you.


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