Shedding Light on Dark Pools

Luis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Aguilar’s recent public statement at an open meeting of the SEC; the full text, including footnotes, is available here. The views expressed in the post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

Today, [November 18, 2015], the Commission considers proposing much-needed enhancements to the regulatory regime for alternative trading systems (“ATSs”) that trade national market system (“NMS”) stocks. I will support these proposals because they could go a long way toward helping market participants make informed decisions as they attempt to navigate the byzantine structure of today’s equity markets.

The Role that ATSs Play in Our Markets Today

ATSs reportedly first appeared in the late 1960s, but they truly began to flourish after the Commission’s 2005 adoption of Regulation NMS. Today, there are more than 40 active ATSs registered with the Commission, and those that trade NMS stocks have, by some estimates, accounted for nearly 18% of all trading in those stocks at various times over the past two years.

That figure represents a more than fourfold increase since 2005, when ATSs accounted for roughly 4% of NMS stock trading. In fact, some ATSs now execute a larger portion of consolidated volume than smaller exchanges do. The ascendance of ATSs in recent years is the result of a confluence of factors, including a prolonged period of subdued market volatility and the ability of ATSs to offer certain advantages, such as attractive fee structures, price improvements, and faster processing speeds, among others.

Yet, perhaps the greatest catalyst for the rise of ATSs in recent years has been institutional investors’ growing need to trade large blocks of stock without causing markets to move against them. This need is not new, but it has become increasingly acute with the advent of algorithmic trading strategies and the diminished order sizes that have resulted. ATSs responded to this need by offering ever more trading on an anonymous basis, and without displaying specific order information before trades occur. These types of ATSs have come to be known as “dark pools.”

Dark pools initially portrayed themselves as havens from predatory traders. They achieved this, in part, by excluding high frequency traders, who supposedly use brute speed to front-run institutional investors’ large orders. Lured by this promise of safety, institutional traders embraced ATSs as a solution to their trading needs. Unfortunately, all too often the safety these investors sought proved illusory.

Bad Things Can Happen in the Dark

Attracting sufficient liquidity to achieve critical mass has proven a continuous challenge for many dark pools. They have addressed this existential problem in various ways. For example, many dark pool operators have allowed their own proprietary trading desks to have access to their pools, while other operators have allowed their affiliates to trade within their pools. And still other operators have given high-speed traders access to their dark pools, all in an attempt to ensure that ATS subscribers will find counterparties for their trades as quickly and consistently as possible.

Setting aside the propriety of these approaches, their adoption suggests that the implacable need that dark pools have for liquidity has intensified certain conflicts of interest between them and their subscribers. The inability to properly manage these conflicts of interest has led the Commission to bring a number of enforcement actions against dark pool operators in recent years. For example, in 2011, the Commission brought an enforcement action against one dark pool operator for falsely advertising that no proprietary trading took place in its dark pool. In reality, one of the operator’s affiliates not only engaged in proprietary trading in the pool, but it also secretly enjoyed unfair informational advantages, which it used to front-run subscribers’ trades.

The lesson from this case, however, apparently fell on deaf ears. For just a few months ago, the Commission settled another enforcement action against one of the oldest dark pool operators because it, too, had failed to disclose that it was engaged in proprietary trading within its pool.

That dark pool operator also gave its proprietary trading desk an unfair informational edge over other subscribers, despite guidance from the operator’s compliance department that this was improper.

Of course, conflicts of interest come in many guises. For example, the Commission has brought enforcement actions against dark pools for failing to protect their subscribers’ confidential information. And, just last year, the Commission brought an enforcement action against one operator of a large dark pool because, among other things, it secretly offered high speed traders special order types that gave them an unfair advantage over other subscribers. Interestingly, this savvy dark pool operator knew how to play both sides of the fence. In addition to giving high frequency traders an unfair edge, this operator secretly allowed certain of its favored subscribers to avoid trading with those very same high frequency traders.

This dismal litany of misconduct by dark pool operators appears to have led at least some market participants to lose faith in the ability of dark pools that are operated by broker-dealers to provide a level playing field. Bereft of regulatory intervention, these market participants seem to be taking matters into their own hands. Nine of the largest asset managers have banded together to form their own dark pool, one that is operated by and open exclusively to institutional investors. According to reports, one of the goals of this new “buy-side institutions only” dark pool is to “eliminat[e] the types of profit driven conflicts of interest that have been seen in some existing venues.” This action by buy-side investors with approximately $14 trillion in assets under management seems to be a clear warning the markets aren’t working as well as they could, a warning that has gone unheeded for far too long.

Shining a Light on Dark Pools

A common thread running through the enforcement actions against dark pools is that market participants lack crucial information about how these ATSs function—and about the serious conflicts of interest they can harbor. Today, the Commission takes steps toward shedding much needed light onto dark pools by requiring certain ATSs to be more transparent, and by requiring them to undergo Commission review to ensure that they qualify for the exemption from registering as an exchange. The rules and amendments proposed today will require ATSs that trade most types of equities to furnish both investors and the Commission with much more detailed information about their operations. Importantly, many of the disclosures that today’s proposal would require should reveal the very types of conflicts of interest that lay at the heart of the enforcement actions brought against dark pools by the Commission and other regulators.

For example, the proposal would require operators of covered ATSs to disclose whether they or any of their affiliates are submitting trades to the ATS, either on a proprietary basis or otherwise. Covered ATSs would also be required to publicly disclose whether they or a subset of their subscribers enjoy any advantages over other subscribers, such as special order types and preferential access to trade information. The proposal would also require covered ATSs to disclose their policies and procedures for ensuring the confidentiality of subscribers’ information, and these ATSs would also have to identify the positions of employees and third parties that have access to this information.

The additional disclosures that would be required under today’s proposal will go a long way toward enabling investors and broker-dealers to make more informed decisions about which ATSs they may wish to route their orders to. But the Commission should not stop there. Instead, the Commission should give careful consideration to whether additional measures are warranted. For example, are the conflicts of interest confronting many ATSs so intractable that ATSs should simply be prohibited from engaging in any activity other than operating the ATS?

In addition, the Commission should dust off its 2009 proposal regarding non-public trading, and determine whether the threshold for ATSs to display their orders should be lowered to account for their much larger role in today’s equity markets.

Additionally, I hope that the Commission will examine whether Regulation ATS should be expanded to include platforms that trade government securities exclusively, and what information those entities should publicly disclose about their operations. The release includes questions on these and other important issues, and I urge commenters to weigh in with their views so that the Commission will be able to pursue new rules with the benefit of the knowledge, views, and experiences of a variety of market participants.

The Road Ahead

Looking more broadly at our evolving market structure, it seems clear that ATSs will continue to play an important role in the coming years. Yet, the precise contours of that role, and the implications it may hold for investors, are not immediately evident. In particular, I think the Commission should explore certain issues as it seeks to better oversee our markets.

  • First, given that the average trade sizes on dark pools that trade equities have fallen to the same levels as those seen on lit exchanges, what is the future of block trading? Does that future differ for large-cap and smaller cap stocks? And does block trading need to be re-conceptualized to account for the algorithm-driven trading that dominates today’s markets? For example, should market participants redefine block trades as a percentage of average daily trading volume, rather than as a fixed number of shares?
  • Second, can ATSs attract sufficient liquidity to remain viable without engaging in the types of misconduct that have given rise to the enforcement actions I mentioned earlier? Can ATSs survive without the participation of high frequency and other algorithmic traders? If not, can ATSs facilitate meaningful block trading?
  • Third, does the current regulatory structure favor the expansion of dark pools? If so, what does this portend for the complexity and fragmentation of our equity markets? Should the Commission consider limiting the growth of equity ATSs, especially if that growth begins to threaten the quality of price discovery, as some studies suggest it might? Alternatively, should the Commission consider curbing the volume of orders that are executed in dark pools, as the second Directive on Markets in Financial Instruments, or MiFID II, will do for smaller orders in Europe? In any case, I think the Commission should monitor this European experiment, and see what lessons can be drawn.
  • Fourth, are ATSs the best model to facilitate block trading? If not, what other approaches might fare better? Why have recent efforts to establish trading venues for block trades failed to return block trading to pre-financial crisis levels, despite clear interest from market participants to engage in such trades?
  • And finally, can ATSs for fixed income securities potentially fill the vacuum created by the retrenchment of traditional broker-dealer activity in those markets?

Clearly, the relentlessly changing nature of our capital markets requires the Commission to be a proactive participant, knowledgeable and informed as to market innovations and trends. The public is not well-served when the SEC lacks information or is merely a passive observer. Today’s proposed rules will enable the Commission, our staff, and the public to have better visibility into what has been a murky segment of the market.

Ultimately, an informed regulator is a more effective regulator, and an effective regulator is vital for investor confidence and market integrity.


In conclusion, I will vote to approve these proposed rules and amendments because they mark a significant step forward in the Commission’s efforts to enhance the oversight of ATSs that play a vital role in today’s equities markets. I remain mindful, however, that there is still much work to do to ensure that investors have access to the types of disclosures they need in order to make informed decisions.

Lastly, I would like to call attention to the efforts of the Division of Trading and Markets, the Division of Economic and Risk Analysis, and the Office of General Counsel and to their hard work and diligence.

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