Dark Pool Disclosures to Users Are Subject of Review by Finra

Securities regulators are examining disclosures by broker-run trading venues known as dark pools, concerned they are not always giving their customers a complete picture of how they work.

The Securities and Exchange Commission and Financial Industry Regulatory Authority have identified “concerns” about alternative trading systems according to a letter Finra published on its website outlining regulatory and examination priorities for 2013. Most of the platforms known as ATSs are private venues owned by brokers that match buy and sell equity orders from customers.

“Finra is conducting a series of examinations of firms that operate an ATS and the firms’ affiliates,” it said in the letter to broker-dealers. The private-sector regulator “is seeking to determine through its examination program whether firms are consistently representing and disclosing various aspects of their ATS operations to their subscribers,” it said.

The announcement detailed a series of initiatives Finra is undertaking to ensure market integrity and limit risks, including a focus on whether algorithmic and high-frequency trading could cause dislocations that hurt investors. Finra will examine brokers to see if high-frequency strategies are tested before and after they’re introduced into the market and make sure they don’t engage in “abusive trading,” the letter said.

Automated Trading

Federal regulators have stepped up scrutiny of stock trading practices that gained dominance in the past decade amid a shift to automation, Daniel Hawke, head of the market-abuse unit in the SEC’s enforcement division, said last year. Dark pools, broker-operated private venues that don’t display quotes publicly, rose to prominence as a way for institutions to buy and sell without moving share prices. Brokers, which have a fiduciary duty to get clients the best execution possible, can also avoid fees charged by exchanges for transactions.

More than 40 such pools now exist to trade U.S. equities, including those run by Credit Suisse Group AG, Goldman Sachs Group Inc., Barclays Plc and Getco LLC. One of their key features is that they don’t identify the brokers and institutions that buy and sell on their systems and publish no information about their orders. The platforms are designed to avoid the market impact of trading requests by keeping them out of view until the moment a transaction is done.

Finra is focusing on how dark pools route, represent and handle customers’ buy and sell requests and what they disclose about the order types they use, the letter said. It’s also probing whether brokers participate in their own dark pool as an agent for clients or on a principal basis, Finra said.

Confidential Data

Other issues are how brokers are paid for their services, how they handle erroneous trades, and how they protect the confidential order information supplied by customers. Finra is reviewing the use of indications of interest, or messages that let automated computer systems outside the dark pool know of buy or sell interest within the venue in order to solicit new orders, according to the letter.

The SEC proposed a rule in 2009 to regulate the use of IOIs by dark pools, increase the data available from the venues after transactions occur and limit the growth of individual platforms. The agency never finalized it. Certain data about transactions in dark pools are provided by brokers to their own clients. Rosenblatt Securities Inc., a broker, and research firm Tabb Group LLC provide information about volume on these venues to customers and the media.

Off Exchange

A third of trading now occurs away from exchanges, up from 16 percent in early 2008, excluding platforms called electronic communication networks that compete with public markets, according to data compiled by Rosenblatt. Dark pools, which accounted for less than half the off-exchange volume in October, tripled their share since the first quarter of 2008, the Rosenblatt data show.

While some critics have associated dark pools with an increase in market opaqueness, regulatory scrutiny has focused on their dealings with clients.

Pipeline Financial Group Inc. settled government allegations in 2011 that it failed to provide the liquidity and confidentiality it advertised to customers of its dark pool. The SEC said in June it was probing Liquidnet Holdings Inc. for possible shortcomings in how the dark-pool owner guarded private information about firms using its platform. eBX LLC agreed to pay an $800,000 penalty to settle charges that it failed to protect customers’ trading information, the SEC said in October.

Finra is also assessing how brokers develop algorithms and trading systems, according to the letter it sent firms. Its evaluation of brokers’ testing and controls may occur through examinations and “targeted investigations,” the regulator said. Finra wants to make sure that legal, compliance and operations staff are involved with the design and development of algorithms and that brokers are monitoring activity to detect potential trading abuses, the letter said.

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