Regulators Seek to Keep Pace with a Quickly Evolving Market Structure

In 2005, the U.S. Securities and Exchange Commission (SEC) established a series of rules known as Regulation NMS (National Market System) to promote transparency and efficiency in U.S. equity securities markets. However, advances in trading technology have frustrated the achievement of those goals. Private trading venues known as dark pools have increased tremendously in popularity since the adoption of Regulation NMS. Unlike traditional lit exchanges, dark pools do not display customer orders. This serves to minimize the market impact of large orders placed by institutional investors. Another important development of the past decade is the growth of high frequency trading firms, which use proprietary algorithms to trade at high speeds. Some high frequency traders engage in predatory behavior to get in or out ahead of transactions.

Regulation NMS, established to ensure traders receive best execution on their orders, may have accelerated the growth of dark venues and high frequency trading by correlating best execution with best price. Securing the best price requires transparency across exchanges and slows execution times. But many institutional investors would rather execute quickly to prevent the market from moving away as the order fills. Furthermore, by slowing down execution, high frequency traders are given time to react to orders before a transaction occurs. Large investors seeking to circumvent the transparency rules began trading on dark venues.

The rapid growth of dark pools has pushed some to engage in deceit as the private trading venues race to secure customers while providing sufficient liquidity to satisfy demand. In 2011, the SEC found that Pipeline Trading Systems LLC, a dark pool operator, misled customers seeking natural counterparties by using customer information to generate liquidity through a wholly owned subsidiary. In 2014, the agency charged Liquidnet Holdings with using confidential information about participants’ trading behavior in marketing materials.

The suit currently garnering attention is New York Attorney General Eric Schneiderman’s pursuit of civil fraud charges against Barclays and its dark pool. The initial complaint, filed on June 25, 2014, alleges that Barclays, in an effort to increase liquidity and create the largest dark pool in the United States, deceived customers by allowing high frequency traders to interact with customers. “In short, contrary to Barclays’ representations that it implemented special safeguards to protect clients from ‘aggressive,’ ‘predatory,’ or ‘toxic’ high frequency traders, Barclays has operated its dark pool to favor high frequency traders.” The complaint asserts that Barclays assured clients that “less than 10% of the trading activity in the pool was ‘aggressive,’ while at the same time secretly indicating to at least one high frequency trading firm that the level of such activity was at least 25%.”

These cases illustrate the challenges faced by regulators trying to improve competition and efficiency in increasingly high tech markets. In a 2014 speech, SEC chairwoman Mary Jo White outlined a series of proposed rule changes to address flaws in the quickly evolving market structure. With respect to dark pools, Ms. White stated that the lack of transparency reduces price accuracy and adversely affects overall market quality. In addition, while dark pools are required to register with the SEC as broker-dealers at inception, that information is not made publicly available under current rules. Consequently, dark venues do not undergo the same level of public scrutiny that traditional lit exchanges must withstand before beginning operation. Ms. White asked her staff to draft a rule that would require dark venues to share more information with the public about how they operate.

Regarding high frequency trading, Ms. White listed several proposed changes to improve regulation of proprietary algorithmic trading. She called for two rules that would address oversight of the firms: “the first, a rule . . . to subject them to [SEC] rules as dealers; and second, a rule eliminating an exception from FINRA [Financial Industry Regulatory Authority] membership requirements for dealers that trade in off-exchange venues. Dealer registration and FINRA membership should significantly strengthen regulatory oversight over active proprietary trading firms and the strategies they use.”

Ms. White also proposed measures to directly regulate trading activities of high frequency trading firms. She hopes to improve efforts to ensure that order and execution data arrive at the national consolidated feed no later than it arrives at the direct feeds of proprietary trading firms. In addition, she asked the commission to consider limiting the activities of these firms during certain periods of heightened volatility where liquidity is most vulnerable to price disruption.

Technology outpaces the law in many fields, and the equity markets are certainly no exception. The SEC and self regulatory organizations play a crucial role because of their ability to quickly adapt to changes in market structure. There is no need to reject disruptive technologies in market operation—even if some are put to use with nefarious intent. Careful regulation alongside these advancements will ultimately promote innovation and efficiency.




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