An overview of the North American dark pools regulatory landscape

The chair of the U.S. Securities and Exchange Commission (SEC) may be changing, but the urgency in addressing issues surrounding dark pools is not. In 2011, former SEC Chair Mary Schapiro commented that although the Dodd-Frank Act did not call out dark pools, the SEC planned to focus on high frequency trading and dark pools (http://financialservices.about.com/od/StrategiesandResearch/a/What-Are-Dark-Pools.htm) Mary Jo White, nominated by President Obama in 2013 to chair the SEC, apparently shares Schapiro’s sentiment on this issue, noting that “high frequency trading, complex trading algorithms, dark pools, and intricate new order types raise many questions and concerns.”

Canada, keeping pace with global regulatory initiatives, published a consultative paper in 2010 to investigate the issues surrounding dark pools and received comments from market participants. Even though the size of dark pools in Canada is much smaller than that of its neighbor south of the border, it is expected that the same drivers for the growth of U.S. dark pools may apply as well.

How are dark pools regulated in North America? According to the International Organization of Securities Commissions (IOSCO) consultation report on Issues Raised by Dark Liquidity, in the U.S, a dark pool could be either an alternative trading system (ATS) or a dealer trading system. Either system must be registered as a broker-dealer, and thus is subject to the laws and regulations applicable to broker-dealers, including, where appropriate, Regulation ATS.

In Canada, dark pools are regulated as ATSs and are subject to requirements, including registration as an investment dealer and membership in a self-regulatory organization such as the Investment Industry Regulatory Organization of Canada (IIROC). Dark pools may also operate as facilities of an exchange and, if so, are subjected to the exchange’s requirements.

The current approach to regulating dark pools in the U.S. and Canada includes:

• Transparency – Dark orders can be mingled with other orders on exchanges. However, within a trading venue, transparent orders receive time priority over dark orders at the same price level. Better priced, visible, immediately accessible limit orders are required to be executed ahead of inferior-priced limit orders. In a word, transparency is favored in trade execution.
  • Pre-trade transparency – In the U.S., based on Regulation ATS, any order held by an ATS, unless strictly between two parties, must be displayed if a predetermined trade size threshold is executed. In Canada, all orders are required to be provided to and disseminated by the information processor.[1] Also, dealers are required to enter client orders of a certain value or size on a transparent venue unless they can provide price improvement in dark pools.
  • Post-trade transparency – Information about trades executed in dark pools must be published immediately. In the U.S., all dark pools must report their trades to the Financial Industry Regulatory Authority (FINRA) within 30 seconds of execution. Although a dark pool is not required to disclose any trading information directly to the public, the information collected by FINRA, including trading volumes, can be made public. In Canada, all trades executed on a dark pool are required to be disseminated to the information processor in real time. Trade information is also disseminated by data vendors. Dark pools trade information is provided to the public, including the specific identifier of the platform.

• Regulatory reporting – In the U.S. and Canada, dark pools must submit quarterly reports that include trade information to the regulator. In the U.S., the information is included in the total exchange trade information without specifying the dark volumes. In Canada, trading information from dark pools is provided to the regulator in real time.

• Market access - In the U.S., dark pools must provide fair access only once a threshold market share is reached. In Canada, on the other hand, the fair access provision does not allow a marketplace to unreasonably prohibit, limit or condition access to its services from the time a dark pool starts its operation.

In reviewing the current regulatory framework in the U.S. and Canada, we can conclude that some of the concerns raised by IOSCO are already addressed. Furthermore, Canada has taken a step closer to IOSCO’s principles than the U.S. These principles encourage:

• Full market transparency and integrity
• Clear priority of transparent orders
• Fair access to market and information
• Stringent regulatory reporting

In October 2012, Canadian regulators implemented new rules on dark pools, including visible orders that will have priority over dark orders in the same marketplace at the same price. The new rules have drawn attention from regulators worldwide, as they carefully observe the impact of the new rules on the dynamic between market protection and growth.

We expect that dark pools, as a key component of the broader market structural change, will be kept in the spotlight of  regulators’ ongoing review of the overall market structure. In addition, high frequency trading has been on regulators’ radar for a while. With recent market developments, more discussion is expected to revolve around the interaction of these two market phenomena.

In the meantime, regulators on the other side of the Atlantic are reviewing and proposing reforms on dark pools in Europe. In the third blog of this three-part series, we will provide an update on the regulatory environment of dark pools in Europe.

What role do you think regulation will play in dark pools in the U.S. and Canada? Join the discussion.

Capco's David Gest and Thomas Riesack contributed to this piece.

[1] Information processors provide a central source of consolidated Canadian equity market data that meets standards approved by regulators. An example would be the TMX Information Processor (TMX IP).