Dark Pools Face SEC Plan to Shine Light on Their Operations

  • Commissioners set to vote on proposal for requiring disclosure
  • Move follows complaints of preferential treatment for traders

Dark pools are about to be put on notice: time to go from black box to open book.

The U.S. Securities and Exchange Commission plans to vote Wednesday on a proposal that would pull back the curtain on the private venues, which have faced complaints that they favor high-frequency traders over other investors. The plan would require they disclose their rules of operation, including whether some traders get preferential treatment.

Dark pools have faced intense scrutiny over the past year from the SEC and regulators including New York Attorney General Eric Schneiderman, who alleged that Barclays Plc lied to customers about the role high-frequency traders played on its platform. Many banks including Credit Suisse Group AG have since published more about how their dark pools work, including whether clients such as mutual funds will have to cross paths with speed traders.

“For the operators this is an opportunity to finally come clean about what’s going on in the pools,” said Dave Lauer, chairman of Healthy Markets Association, an advocacy group whose members include Janus Capital Group Inc. and Boston Company Asset Management LLC. “Some have been very transparent, and some haven’t been at all.”

Important Role

Long-term investors such as mutual funds historically have used dark pools to trade large orders without tipping the market to their intentions. But high-frequency traders also play an important role on the platforms, because they provide liquidity to ensure buy and sell orders get filled. The off-exchange markets don’t disclose prices of orders before they are executed and, unlike exchanges, don’t have to treat all investors equally as long as those rules are transparent.

Private trading venues operated by Wall Street brokers such as Credit Suisse, UBS Group AG, Goldman Sachs Group Inc. and Morgan Stanley accounted for about 16.25 percent of U.S. stock-trading volume in September, according to recent research by Rosenblatt Securities Inc.

‘Flash Boys’

The SEC’s proposal comes more than a year after Chair Mary Jo White said dark pools should provide more information about the firms that use them. Her announcement followed the publication of Michael Lewis’s book “Flash Boys,” which alleged proprietary traders used hyper-fast connections between markets to pick off investors whose orders sat in dark pools that used slower price feeds. The plan also comes on the heels this year of several enforcement cases in which the SEC accused dark pool operators of misleading investors about how the platforms work.

Investment Technology Group Inc. agreed to pay $20.3 million in August to settle SEC claims that it ran a secret desk that used knowledge of client orders to trade for its own benefit. In January, UBS consented to pay $14.4 million over allegations that it created special order instructions that benefited high-frequency traders and didn’t tell other clients about them.

Barclays has publicly denied Schneiderman’s charges and has been fighting the case in court. The bank and the New York attorney general are negotiating a possible settlement, according to a person with knowledge of the matter. The SEC could settle with Barclays ahead of Schneiderman’s office, this person said.

White has said she wants dark pool operators to publish a filing known as Form ATS, which stands for alternative trading system and explains how the venues work. Many brokers over the past year have posted the forms on their websites voluntarily, giving investors a fuller understanding of who trades on the platforms.

Enhanced Disclosure

At a U.S. House hearing Wednesday, White said dark pools have become an “important component of our current market structure, as they compete directly with national securities exchanges.” The agency’s rules will require more public disclosure, she said.

“Since the UBS case, you’re starting to see more of the major operators make available more information than was previously available, and they’re also simplifying their operations so they have fewer things to disclose,” said Justin Schack, head of market structure at Rosenblatt.

While the proposal will add some new compliance hurdles for dark pools, brokers and industry lobbyists don’t expect the SEC will propose the venues start publicly displaying every price quote they receive, as stock exchanges do.

Carol Danko, a spokeswoman for the Securities Industry and Financial Markets Association, declined to comment. Sifma’s members include brokers that operate some of the largest dark pools.

SEC spokesman John Nester declined to comment on the agency’s proposal. It will be released Wednesday ahead of a vote by the SEC’s four commissioners on whether to seek public comment.

It remains to be seen how much new information the SEC will require dark pool operators to provide. Lauer’s group has advocated for brokers to disclose quality metrics that would foster comparisons between dark pools, such as how often brokers send clients’ orders to their own dark pool rather than competing venues.

“That is an area in desperate need of transparency and is the main topic underpinning almost every enforcement case -- this relationship between the routing desk and the dark pool,” Lauer said.

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