Reforming the murky depths of Wall Street: Putting the spotlight on the Security and Exchange Commission's regulatory proposal concerning dark pools of liquidity

George Washington Law Review

Volumn 78, Issue 5, 2010, Pages 1032-1050

  Hatch, Robert ^a  

^a GEORGE WASHINGTON UNIVERSITY   (United States)

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EID: 77956089379     PISSN: 00168076     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Review

References (160)

1. LOUIS D. BRANDEIS, OTHER PEOPLE'S MONEY AND HOW THE BANKERS USE IT 92 (1914).
2. See LARRY D. SODERQUIST & THERESA A. GABALDON, SECURITIES REGULATION 2 (6th ed. 2006).
3. According to the SEC, trading in dark pools accounted for 7.2% of the total U.S. trading volume in publicly traded stocks. See Regulation of Non-Public Trading Interest, 74 Fed. Reg. 61, 208, 61, 209 (proposed Nov. 13, 2009) (to be codified at 17 C.F.R. pt. 242) [hereinafter SEC Dark Pools Proposal], available at http://ww.sec.gov/rules/proposecV2009/34-60997.pdf.
4. Securities Act of 1933, 15 U.S.C. § 77b(b) (2006); Securities and Exchange Act of 1934, 15 U.S.C. § 78c(f) (2006).
5. See infra Part I.
6. See Alexandra Zendrian, Don't Be Afraid of the Dark Pools, FORBES.COM, May 18, 2009, http://www.forbes.com/2009/05/18/dark-pools-tradmg-intelligent- investing-exchanges.html.
7. See SEC Dark Pools Proposal, supra note 3, at 61, 208.
8. See id. at 61, 209.
9. See infra Part II.
10. See infra Part III.
11. See SEC Dark Pools Proposal, supra note 3, at 61, 235-38.
12. Mary L. Schapiro, Chairman, U.S. Sec. & Exch. Comm'n, Statement on Dark Pool Regulation Before the Commission Open Meeting (Oct. 21, 2009), available at http://sec.gov/news/speech/2009/spchl02109mls.htm.
13. BLACK'S LAW DICTIONARY 1015 (9th ed. 2009).
14. See id.
15. See SEC Dark Pools Proposal, supra note 3, at 61, 208.
16. Erik R. Sirri, Dir., Div. of Trading and Mkts., U.S. Sec. & Exch. Comm'n, Keynote Speech at the SIFMA 2008 Dark Pools Symposium (Feb. 1, 2008), available at http://sec.gov/news/speech/2008/spch020108ers.htm.
17. See id.
18. See, e.g., 17 C.F.R. § 242.603 (2009) (mandating public access to stock quotations).
19. Order Execution Obligations, Exchange Act Release No. 34-37619A, 61 Fed. Reg. 48, 290, 48, 293 (Sept. 12, 1996).
20. See id.
21. SEC Dark Pools Proposal, supra note 3, at 61, 209 n.4.
22. See id.
23. See Interview by Steve Forbes with Seth Merrin, CEO, Liquidnet (Feb. 16, 2009), available at http://www.forbes.com/2009/02/13/seth-merrin-transcript- intelugent-investing-0216-mer-rin.html.
24. SEC Dark Pools Proposal, supra note 3, at 61, 208 n.4.
25. Regulation NMS-Regulation of the National Market System, 17 C.F.R. §§ 242.600-.612 (2009).
26. Donald C. Langevoort, U.S. Securities Regulation and Global Competition, 3 Va. L. & Bus. Rev. 191, 202-03 (2008).
27. 17 C.F.R. § 242.603.
28. Id. § 242.610 (also known as the Order Access Rule).
29. Id. § 242.611 (also known as the Order Protection Rule).
30. See U.S. Sec. & Exch. Comm'n, Commission Notice: Decimals Implementation Plan for the Equities and Options Markets (July 24, 2000), available at http://www.sec.gov/rules/other/decimalp.htm.
31. David Bogoslaw, Big Traders Dive into Dark Pools, Bus. Week Online, Oct. 3, 2007, http://www.bussiessweek.com/print/investor/content/oct2007/pi2007102- 394204.htm.
32. Id.
33. Id.
34. Securities and Exchange Act of 1934, 15 U.S.C. §§ 78a-78mm (2006).
35. See 17 C.F.R. § 242.601 (2009) (requiring only national securities exchanges to make detailed reports of their quotes and transactions).
36. 15 U.S.C. § 78e.
37. Regulation ATS-Alternative Trading Systems, 17 C.F.R. §§ 242.300-.303 (2009). Trading venues defined as "alternative trading systems" do not have to file reports under Regu-lation NMS. See id. § 242.601.
38. See id. § 242.601.
39. See Regulation of Exchanges and Alternative Trading Systems, Exchange Act Release No. 34-40760, 63 Fed. Reg. 70, 844, 70, 847 (Dec. 22, 1998).
40. 17 C.F.R. § 242.301(b)(1).
41. Id. § 242.302(b)(5)(B).
42. See Regulation of Exchanges and Alternative Trading Systems, 63 Fed. Reg. at 70, 847.
43. Keith Fitz-Gerald, Are "Dark Pools" Destined to Be the Capital Markets' Next Black Hole?, MoneyMorning.com, July 10, 2008, http://www. moneymorning.com/2008/07/10/dark-pools/.
44. The CTA is a self-regulatory organization. See SEC Dark Pools Proposal, supra note 3, at 61, 218. Pursuant to Regulation NMS, the CTA has authority from the SEC to enact binding requirements that broker-dealers (including ATSs) must follow in reporting on the trades that they conduct. See 17 C.F.R. § 242.601.
45. See SEC Dark Pools Proposal, supra note 3, at 61, 218-20.
46. See id.
47. Peter Chapman, Credit Suisse Lobbies for 'Fairer' Access to Dark Pools, TRADERS MAG., June 13, 2008, http://www.tradersmagazme.coin/news/101154-1.html.
48. Interview by Steve Forbes with Seth Merrin, supra note 22.
49. See Mary Lou Von Kaenel & Greg Malatestinic, Do Black Swans Swim in Dark Pools?, Automated Trader, Second Quarter 2008, at 14, 15-16.
50. Bogoslaw, supra note 29 (mentioning the example of Liquidnet, a large dark liquidity provider that charges customers two cents per share to execute a trade).
51. Id.
52. See Peter Chapman & Nina Mehta, 2008 Review: IOls Expand and Do More Heavy Lifting, TRADERS MAG., Dec. 2008, at 56, available at http://www. tradersmagazine.com/issues/20-289/102773-1.html.
53. Zendrian, supra note 6.
54. 17 C.F.R. § 242.600(b)(8) (2009).
55. See Zendrian, supra note 6.
56. Chapman & Mehta, supra note 50, at 56.
57. Liz Peek, 'Dark Pools' Threaten Wall Street, N.Y. SUN, Oct. 16, 2007, at 1, available at http://www.nysun.com/business/dark-pools-threaten-wall-street/ 64598/.
58. Jonathan Spicer, Bank-Run Dark Pools Swelling in U.S. Stock Markets, REUTERS, June 3, 2009, http://www.reuters.com/article/domesticNews/ idUSTRE5530IG20090604.
59. Peek, supra note 55.
60. Id.
61. Alexandra Zendrian, NYSE Hearts Liquidnet, Forbes.com, June 8, 2009, http://www.forbes.com/2009/06/08/nyse-euronext-liquidnet-markets-dark-pools. html.
62. This partnership is only one instance of many attempts by conventional trading platforms to give their customers more access to dark liquidity. See, e.g., Jeremy Grant, BATS Europe Reveals Plan for Dark Pool, FIN. TIMES, June 29, 2009, at 20.
63. Fitz-Gerald, supra note 41.
64. See Peek, supra note 55, at 1.
65. See Sirri, supra note 15.
66. See infra Part II.
67. See, e.g.. Chapman & Mehta, supra note 50, at 56.
68. Peek, supra note 55.
69. See Fitz-Gerald, supra note 41.
70. Peek, supra note 55, at 1.
71. See Fitz-Gerald, supra note 41.
72. See Peek, supra note 55, at 1.
73. Tyler Durden, Goldman Now Dominating Dark Pool Trading; Who Is Sigma X?, posting to Zero Hedge (June 7, 2009, 12:52 PM), http://zerohedge.blogspot.com/ 2009/06/goldman-now-dominating-dark-pool.html.
74. Spicer, supra note 55.
75. Id. One Canadian bank officer noted that there would be "instant vilification from the rest of the public" if a Canadian ever sought to launch a dark pool.
76. Id.
77. Daria Mercado, Exchanges Could Drown in Dark Pools, INVESTMENT NEWS, Sept. 12, 2007, http://www.investmentnews.com/article/20070912/REG/70912008.
78. Sirri, supra note 15.
79. Sirri admitted that a large percentage of trade volume had shifted from traditional exchanges, but he believed a large majority of those trades were now conducted on public electronic exchanges, as opposed to dark pool venues. Id.
80. Spicer, supra note 55. This report projected that overall market share of dark pools would stay at about nine percent.
81. Id.
82. "The volume in the dark pools is very overstated. There are a lot of issues with people claiming volume where there isn't." Daria Mercado, Exec Claims Dark-Pool Volumes Are Hyped, INVESTMENT NEWS, May 6, 2008, http://www.investmentnews.com/apps/pbcs.dll/article?AID=/20080506/REG/111847616/ -l/BreakingNews04 (quoting Andrew Silverman, Managing Director of Morgan Stanley). Silverman estimated that, at that time, dark pool volume comprised 5-9% of U.S. equity trades, not the 10-20% that many analysts believed. Id.
83. See Sirri, supra note 15.
84. See, e.g., Heather Stewart, IMF Says US Crisis Is "Largest Financial Shock Since Great Depression," THE GUARDIAN, Apr. 9, 2008, http://www.guardian.co.uk/business/2008/apr/09/useconomy.subprimecrisis.
85. Kevin McCoy, SEC Chief Urges Oversight of Credit-Default Swaps, USA TODAY, Sept. 26, 2008, at 2B.
86. John Poirier & Rachelle Younglai, U.S. Regulators Ready Laws for OTC Derivatives Crackdown, REUTERS, June 10, 2009, http://www.reuters.com/article/ ousiv/idUSTRE55AoLK20090611.
87. See OFFICE OF INVESTIGATIONS, U.S. SEC, INVESTIGATION OF FAILURE OF THE SEC TO UNCOVER BERNARD MADOFF'S PONZI SCHEME 1 (2009), available at http://www.sec.gov/news/studies/2009/oig-509.pdf.
88. See, e.g., McCoy, supra note 75, at 2B.
89. Mary L. Schapiro, Chairman, U.S. See. & Exch. Comm'n, Address Before the New York Financial Writers' Association Annual Awards Dinner (June 18, 2009), available at http://www.sec.gov/news/speech/2009/spch061809mls-2.htm. The other areas of emphasis that Schapiro mentioned were target date funds, municipal securities, and the fiduciary duties of investment advisors. Id.
90. Id.
91. See id.
92. see also James A. Brigagliano, Co-Acting Dir., Div. of Trading and Mkts., U.S. Sec. & Exch. Comm'n, Keynote Address to the 2009 SIFMA Market Structure Conference (May 20, 2009), available at http://www.sec.gov/news/ speech/2009/spch052009jab.htm.
93. Id.
94. See id.
95. See Letter from Charles E. Schumer, U.S. Senator, to Mary L. Schapiro, Chairman, U.S. Sec. & Exch. Comm'n (July 24, 2009), available at http://schumer.senate.gov/new-website/re-cord.cfm?id=316252.
96. The Commission responded to the Senator's request by proposing rules to ban all flash orders. Press Release, U.S. Sec. & Exch. Comm'n, SEC Proposes Flash Order Ban (Sept. 17, 2009), available at http://ww.sec.gov/news/press/ 2009/2009-201.htm.
97. Nina Mehla, Schumer and Niederauer Call for Greater Dark Pool Scrutiny, TRADERS MAG., Oct. 20, 2009, http://www.tradersmagazme.com/news/schumer- niederauer-dark-pools-104523-1.html.
98. Jonathan Weil, Goldman Sachs Loses Grip on Its Doomsday Machine, BLOOMBERG NEWS, July 9, 2009, http://www.bloomberg.com/apps/news?pid= newsarchive&sid=aFeyqdzYcizc.
99. Id.
100. See Landon Thomas Jr., Inquiry Stokes Unease over Trading Firms that Shape Market, N.Y. TIMES, Sept. 4, 2009, at B1.
101. See Durden, supra note 66.
102. see also Joe Hagan, The Dow Zero Insurgency, N.Y. MAG., Oct. 5, 2009, at 30, 32, available at http://nymag.com/guides/money/2009/59457/(discussing the blogging efforts of Dan Ivandjiiski and the influence of his postings on Zero Hedge).
103. Jacob Bunge, NYSE Teams with Dark Pools to Boost Transparency, MARKETWATCH, Oct. 20, 2009, http://www.marketwatch.com/story/nyse-teams-with- dark-pools-to-boost-trans-parency-2009-10-20.
104. Mehta, supra note 84.
105. Letter from Robert Greifeld, President & CEO, NASDAQ, to Mary Schapiro, Chairman, U.S. Sec. & Exch. Comm'n (July 27, 2009) (on file with author).
106. Geoffrey Rogow & Jacob Bunge, Dark Pools Fire Back at Call for Ban, WALL ST. J. ONLINE, July 31, 2009, http://online.wsj.com/article/ SB124906083065697257.html ("In interviews with nearly a dozen dark-pool executives, none objected to the SEC's initiative. Dark-pool administrators are willing to provide more transparency and standardize volume reporting ....").
107. Seth Merrin, the CEO of Liquidnet, one of the nation's large independent dark pools, has cautioned that "[i]f they do something that makes the dark pool light and eliminates the reasons for institutions to trade on our vehicles, that would be a disaster for a hundred million people out there." Jonathan Spicer, SEC Spotlight Puts "Dark Pool" Venues on Defensive, REUTERS, June 19, 2009, http://www.reuters.com/article/idUSN1946216120090619.
108. " 'Undisplayed liquidity adds to execution quality.... You can come up with all kinds of anecdotes, but the simple fact is, on behalf of all investors, dark liquidity adds to execution.'" Rogow & Bunge, supra note 91 (quoting Bob Gasser, CEO of Investment Technology Group).
109. see also Zendrian, supra note 6.
110. See SEC Dark Pools Proposal, supra note 3.
111. See id.
112. Id. at 61, 209-10.
113. Id. at 61, 210, 61, 213.
114. Id. at 61, 210, 61, 236-37.
115. See Brigagliano, supra note 80.
116. See SEC Dark Pools Proposal, supra note 3, at 61, 219.
117. See id. at 61, 208 n.4.
118. See id.
119. See Mercado, supra note 72.
120. Rogow & Bunge, supra note 91. Dark pool operators will further find the new disclosure rule palatable because it would not require immediate disclosure for trades executed at the cost of $200, 000 or more. SEC Dark Pools Proposal, supra note 3, at 61, 220.
121. See SEC Dark Pools Proposal, supra note 3, at 61, 232.
122. See Chapman, supra note 45 (noting how lax reporting rules made access rules under Regulation ATS "weak and unenforceable").
123. SEC Dark Pools Proposal, supra note 3, at 61, 209-10.
124. Nina Mehta, Reg ATS 5% Threshold Could Get Lowered, TRADERS MAG., Aug. 14, 2009, http://www.tradersmagazine.cora/news/sec-reg-ats-display-fair-access- five-percent-104254-1.html.
125. SEC Dark Pools Proposal, supra note 3, at 61, 215.
126. See Mehta, supra note 107. no 107.
127. Id.
128. Chapman, supra note 45. "'You can't run a line to somebody for one month for one security.... When they envisioned that rule it was in the days of the telephone. But nowadays there is [more] connectivity required.' " Id. (quoting Dan Mathisson of Credit Suisse).
129. See, e.g., Letter from William P. Neuberger and Andrew F. Silverman, Managing Dirs., Morgan Stanley Elec. Trading, to U.S. Sec. & Exch. Comm'n 6 (Mar. 4, 2010), available at http://sec.gov/comments/s7-27-09/s72709-74.pdf.
130. Letter from Greg Tusar, Managing Dir., Goldman Sachs Execution & Clearing, L.P., and Matthew Lavicka, Managing Dir., Goldman Sachs & Co., to U.S. Sec. & Exch. Comm'n 3 (Feb. 17, 2010), available at http://sec.gov/comments/s7-27-09/s72709-48.pdf (suggesting a one-percent threshold).
131. See Rachelle Younglai, SEC Proposes to Shed Light on "Dark Pools," REUTERS, Oct. 21, 2009, http://www.reuters.com/article/ idUSTRE59K50K20091021.
132. Letter from William P. Neuberger and Andrew F. Silverman to U.S. Sec. & Exch. Comm'n, supra note 112, at 3-4.
133. See Younglai, supra note 113.
134. Id. (quoting Adam Sussman, director of research for TABB Group Consultants).
135. See Sirri, supra note 15 (discussing the effects of dark pool fragmentation).
136. A possible manifestation of this problem might exist if small investors begin to submit bids to dark pools that diverge from the best public quote available on the off chance that they may be accepted. See Zendrian, supra note 6 (dark pool executive suggesting the benefits of this course of action).
137. Erik Sirri stated strongly that it was not the Commission's duty to ban investing using dark pools. Sirri, supra note 15 ("A common misunderstanding of the Commission's approach to price transparency is that it requires the display of liquidity and thereby drives trading off the public markets. This is not true.").
138. Id.
139. See Langevoort, supra note 24, at 203-04.
140. For example, it would take five to six dark pools traded at the proposed level to complete the current amount of trading activity that occurs on Sigma-X, the dark pool operated by Goldman Sachs. See Mehta, supra note 107.
141. At least one industry consultant, TABB Group, has concluded that there is no evidence that dark pool volume should be curtailed. Younglai, supra note 113.
142. see also Letter from Larry Tabb, Founder & CEO, TABB Group, to U.S. Sec. & Exch. Comm'n 4 (Dec. 8, 2009), available at http://sec.gov/comments/ s7-27-09/s72709-21.pdf (comment letter in response to the SEC dark pools proposal).
143. One resulting difference would be increased routing costs to customers, who would presumably have to pay for the multiple organizations involved in completing their trade.
144. See Zendrian, supra note 6 (noting that while IOIs increase trade liquidity, they can also be used to manipulate the market); Letter from Leonard J. Amoruso, Gen. Counsel, Knight Capital Group, to U.S. Sec. & Exch. Comm'n 3-4 (Feb. 24, 2010), available at http://sec.gov/comments/s7-27-09/s72709-68.pdf (example of one of the many comment letters the SEC has received regarding IOIs).
145. See Zendrian, supra note 6.
146. Letter from Leonard J. Amoruso to U.S. Sec. & Exch. Comm'n, supra note 124.
147. See Rogow & Bunge, supra note 91.
148. Brigagliano, supra note 80.
149. see also SEC Dark Pools Proposal, supra note 3, at 61, 208, 61, 211.
150. Part of this lack of clarity stems from the fact that the SEC proposal does not define specifically what types of IOIs are actionable or forced to be made public. See SEC Dark Pools Proposal, supra note 3, at 61, 212-13.
151. See Langevoort, supra note 24, at 202-04.
152. Zendrtan, supra note 6.
153. See FIN. INDUS. REGULATORY AUTH., REGULATORY NOTICE 09-29, ORIGINATION AND CIRCULATION OF RUMORS (2009), available at http://www.fmra.Org/web/groups/ industry/@ip/@reg/@notice/documents/notices/p118807.pdf.
154. FINRA is a self-regulatory organization that is tasked with creating and implementing standards to ensure fairness in trading markets. See Carrie Johnson, SEC Approves One Watchdog for Brokers Big and Small, Wash. Post, July 27, 2007, at D2.
155. For example, it took the NASDAQ five years to gain SEC approval to become a national securities exchange. Compare The Nasdaq Stock Market, Inc., Notice of Filing Application for Registration as a National Securities Exchange, Exchange Act Release No. 34-44396, 66 Fed. Reg. 31, 952 (June 7, 2001), available at http://www.sec.gov/rules/other/34-44396.htm (indicating that NASDAQ submitted its application to become a national securities exchange to the SEC on Mar. 15, 2001), with Press Release, NASDAQ OMX, SEC Approves NASDAQ's Exchange Registration Application (Jan. 16, 2006), available at http://ir.nasdaqomx.com/releasede-tail.cfm?ReleaseID=184424 (announcing the SEC's approval of the NASDAQ on January 16, 2006).
156. See, e.g, SEC Release No. 34-44396, supra note 132, at 31, 953.
157. See Regulation ATS-Alternative Trading Systems, 17 C.F.R. §§ 242.300-.303 (2009).
158. See Von Kaenel & Malatestinic, supra note 47, at 16 (discussing how complex trading practices may have undiscovered risks).
159. See Interview by Steve Forbes with Seth Merrin, supra note 22.
160. See supra notes 65-67 and accompanying text.