Wednesday, November 18, 2015, was a busy day for the Securities and Exchange Commission. That morning the Commission convened to propose
new rules to enhance the transparency of alternative trading systems, including “dark pools.” Later that day, Chairman Mary Jo White testified before Congress about the Commission’s plans to combat disruptive trading, to require registration “of certain active proprietary traders and improvements of firms’ risk management of trading algorithms,” as well as plans for rules addressing pre-trade pricing transparency in fixed income markets. The very next Wednesday, in what appears to be a coordinated approach to the SEC’s, the CFTC
proposed its own set of rules designed to take on automated trading and disruptions that can be caused by rapid algorithmic trading.
Dark Pools
The first dark pools started out in the late 1960s, portraying themselves as havens from predatory traders. And for most of their existence, they operated that way. Since the mid-2000s, however, in an effort to ensure that dark pool subscribers find counterparties for trades quickly and consistently, many dark pool operators have given high-speed traders access to their dark pools. In addition, some operators have allowed their own proprietary trading desks as well as those of their affiliates to trade within their pools. This has created an environment rife with conflicts of interest between dark pool operators and their clients.
Some of this conflict and apparent self-dealing is an unintended consequence of the SEC’s own regulations. The adoption of Regulation NMS in 2005, the SEC’s effort to democratize pricing data, ensure best price execution for investors, and foster competition among individual markets opened the door for those who were able to use advances in computer trading technologies to exploit arbitrage opportunities among the multitude of new exchanges.
The SEC’s proposed new rules do not make any changes to Regulation NMS. Rather, the new rules are focused primarily on the transparency of alternative trading systems (ATS), including “dark pools.” The proposed rules, if adopted, would require broker-dealers operators and their affiliates to publicly disclose detailed information about the operations and activities of their ATSs. The proposals would also enhance the ability of the SEC to oversee ATSs.
These proposed new rules would apply to only to ATSs that trade stocks that are listed on a national securities exchange. The rules would require that each applicable ATS file with the SEC on a new Form ATS-N, among other things, information about its broker-dealer operator and affiliates, as well as the nature of its operations. The contents of every Form ATS-N and any amendments would be posted on the SEC’s website. In addition, each ATS would be required to maintain a publicly available website with:
- access to its active Form ATS-N;
- information regarding differences in the availability of services and processes available to subscribers as opposed to the broker-dealer operator, as well as types of orders;
- segmentation of order flow;
- procedures governing trading during a suspension; and
- opening, reopening and closing processes.
ATS operators 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 registration of ATSs would provide the SEC with some regulatory oversight of ATSs via review all Form ATS-Ns. This review would them the power to declare them effective or ineffective, thereby giving them the ability shut down noncompliant ATSs.
Comments on the proposed rules will be due by early to mid-February, 60 days after publication of the proposal in the Federal Register.
Disruptive Trading
- The registration status of certain active proprietary traders and improvements to firms’ risk management of trading algorithms;
- Enhanced disclosure requirements concerning a broker’s order routing practices;
- An anti-disruptive trading rule that would address the use of aggressive, destabilizing trading strategies in vulnerable market conditions; and
- The development and implementation of a consolidated audit trail.
In addition, Chairman White testified that the Commission Staff is looking into pre-trade pricing transparency in fixed income markets, particularly with respect to ATSs and other electronic trading networks:
"With respect to our fixed income markets, I have directed SEC staff to undertake an initiative designed to enhance the public availability of pre-trade pricing information in the fixed income markets. This initiative builds on a recommendation in the Commission’s July 2012 Report on the Municipal Securities Market, and would potentially require the public dissemination of the best prices displayed by market participants on electronic systems, such as ATSs and other electronic dealer networks, in the corporate and municipal bond markets. This potentially transformative change would broaden access to pricing information that today is available only to select parties, and could facilitate enhanced execution, improve market efficiency, and promote price competition. I am mindful, however, of the need to strike the right balance of compelling the disclosure of meaningful pre-trade pricing information without discouraging market participants from producing such information. Accordingly, to help inform our initiative on pre-trade price transparency, we have been actively engaged in discussions with market participants, FINRA, and the Municipal Securities Rulemaking Board (MSRB). Before we take any actions, I also anticipate careful staff analysis of the pricing data already available to assess how best to achieve our regulatory objectives."
Automated Trading
One week later, on November 24, 2015, the
CFTC proposed rules intended to be a comprehensive regulatory response to the evolution of automated trading on U.S. designated contract markets (DCMs). The proposed rules, known collectively as Regulation Automated Trading or Regulation AT, represent a series of risk controls, transparency measures, and other safeguards to enhance the U.S. regulatory regime for automated trading. According to the CFTC:
"Regulation AT takes a multilevel approach by proposing risk control and other requirements for (a) market participants using algorithmic trading systems (ATSs), who are defined as “AT Persons” in the rulemaking, (b) clearing member futures commission merchants (FCMs) with respect to their AT Person customers, and (c) DCMs executing AT Person orders. The proposed rules are intended to reduce potential risks arising from algorithmic trading activity, by requiring the implementation of risk controls such as maximum order message and maximum order size parameters, and the establishment of standards for the development, testing, and monitoring of ATSs, among other requirements. AT Persons and clearing member FCMs would also be required to submit reports on their risk controls to DCMs, and maintain books and records regarding their risk controls and other algorithmic trading procedures for review by DCMs."
Recognizing that markets and trading technologies move faster than regulation, the proposed rules would "require that all AT Persons become members of a registered futures association (RFA), and further require RFAs to consider membership rules addressing algorithmic trading for each category of member in the RFA. Taken together, these provisions would allow RFAs to supplement elements of Regulation AT in response to future industry developments."
The notice of proposal will be open for a 90-day public comment period following publication of the release in the Federal Register.