FINRA Files a Proposed Rule Change to Make Dark Pool Trading More Transparent

The Financial Industry Regulatory Authority Inc. (“FINRA”) filed with the U.S. Securities and Exchange Commission (“SEC”) its anticipated, proposed rule change impacting alternative trading systems (“ATSs”), such as dark pools and electronic communications networks.¹ The proposal would require an ATS to report to FINRA weekly volume information and the number of securities trades (both equity and debt) within the ATS, and to acquire and use a single, unique market participant identifier (“MPID”) for reporting information. FINRA would then make the reported volume and trade count information (for equity securities only) publicly available on its website.

The proposal, if adopted, would increase transparency into dark pools by improving available information concerning specific stock prices and liquidity. It also would give FINRA the capability to decipher ATS trading from other trading at a given broker-dealer, and improve FINRA’s ability to surveil for compliance with the display obligations and fair access requirements in Regulation ATS² — thereby likely leading to more disciplinary actions against member firms. 

This alert provides background on ATSs and summarizes the key components of the proposal.

I. Background

Regulation ATS,³ which was adopted in 1988, exempts ATSs⁴ from registering as exchanges, while requiring them to register as broker-dealers.⁵ Additionally, for an ATS that reaches 5% or more of the average daily trading volume for any given security during at least four of the preceding six calendar months, the Regulation requires the ATS to provide fair execution access to non-subscribers, and imposes associated recordkeeping requirements.⁶ 

In recent years, the use of dark pools has increased, with trading on ATSs regularly comprising 10-15% of U.S. equity trading volume.⁷ With that increase has come an increase in regulatory scrutiny, and the proposed rule change is directed, in part, at improving FINRA’s ability to surveil for compliance with Regulation ATS. As detailed in the rule proposal, current reporting requirements for ATSs are deficient in two respects:⁸ 

1. First, Regulation ATS requires each ATS to report to the SEC on a quarterly basis, via Form ATS-R, its total unit volume of transactions and total dollar volume of transactions for certain categories of securities as specified in the rule. However, the volume reporting is not on a security-by-security basis and is only based on quarterly volume, whereas the fair access, order display, and execution access requirements are triggered on a security-by-security basis for equity securities, and are based on monthly volume numbers rather than quarterly volume numbers. Consequently, the current ATS reporting obligations do not provide sufficient information to determine whether an ATS has exceeded the volume thresholds in Regulation ATS.⁹ 
2. Second, current trade reporting data does not provide a definitive way to assess whether an ATS has reached the volume thresholds in Regulation ATS. Although each over-the-counter securities transaction in which an ATS is involved must be reported under FINRA rules, a broker-dealer that operates an ATS may report trades executed within a particular ATS using the same MPID it uses for transactions it executes in other areas of its business. Thus, current trade reporting data does not specify which trades were executed within an ATS, and therefore is insufficient for purposes of surveiling for compliance with the display obligations and the fair access requirements in Regulation ATS.¹⁰ 

As detailed below, the rule proposal attempts to close these gaps between the information firms are required to report and the information FINRA apparently believes it needs to determine if firms are Regulation ATS compliant.

FINRA also plans to make some of the reported volume and trade count information publicly available on its website.¹¹ While many dark pools provide data to third party firms which publish estimated statistics on dark pool trading volumes, not all dark pools participate in such voluntary reporting and the consistency of how participating dark pools report information has sometimes been uncertain. Thus, the proposal could improve the quality of the information that is made public.

II. FINRA’s Proposal

A.  Volume and Trade Count Reporting

Under the proposed rule change, proposed new Rule 4552 would require an ATS covered by the Rule¹² to report to FINRA its aggregate weekly volume information and number of trades, by security (both equity and debt), for those securities subject to FINRA trade reporting requirements.¹³ Such reporting would be required within seven days after the end of each calendar week.¹⁴ Additionally, proposed Rule 4552 would seek to capture information about trades executed within an ATS only (rather than routed away from the ATS), and treat a cross-trade executed within an ATS as a single trade (i.e., a 1,000 share buy order crossed with a 1,000 share sell order would be calculated as 1,000 shares of total trading volume).¹⁵

B. Publishing by FINRA

While FINRA plans to make some of the reported volume and trade count information publicly available, that information will be more limited in scope than the information subject to reporting requirements, and will be published on a delayed basis:

1. Although the proposal would require firms to report volume and trade information relative to both equity and fixed-income securities, FINRA will publish information relative to equities only.¹⁶ FINRA states that it intends to evaluate the data received from ATSs concerning fixed-income securities, but that it does not intend to publish the related trading information until that evaluation process has been completed.¹⁷ 
2. For NMS stocks in Tier 1 of the NMS Plan to Address Extraordinary Volatility (the “Plan”) (e.g., those NMS stocks in the S&P 500 Index, the Russell 1000 Index, and certain exchange-traded products, as specified in the Plan) FINRA is proposing to “initially” publish the reported information on a two-week delayed basis.¹⁸ 
3. For all other NMS stocks and OTC Equity Securities subject to FINRA’s trade reporting requirements, FINRA is proposing to publish the reported information on a four-week delayed basis.¹⁹ 

FINRA seems to be trying to strike a balance between allowing investors to trade often large blocks of stock in the dark and thereby avoid predatory trading or large market movements, with adding transparency to individual stock prices and liquidity to improve competition.

If the SEC approves the proposal, FINRA’s publication of market data will follow the trend recently begun by the SEC itself. On October 9, 2013, the SEC launched a new website to serve as a central location for the SEC to publish transaction data culled from its Market Information Data Analytics System (“MIDAS”), which the SEC launched earlier this year.²⁰ MIDAS provides the SEC with data about every displayed order for U.S. listed equities posted on national exchanges, time-stamped to the microsecond.²¹ The information is sourced from the consolidated tapes and proprietary feeds of each exchange and includes posted orders and quotes, modifications and cancelations, and trade executions both on- and off-exchange.²² The website also contains an interactive charting tool that allows users to compare and contrast data series according to the type of security, market capitalization, volatility, price, and turnover.²³ Typically, only sophisticated market participants have had access to all of this data, whereas only dark pool subscribers and subscribers to ATS data reporting outlets have had access to dark pool trading data.

It is possible that, between the data the SEC is publishing and the data FINRA proposes to publish, there will be some leveling of the playing field, between high speed and dark pool traders and less sophisticated investors. At a minimum, the new data will take some of the guesswork out of understanding certain market activity, for interested sophisticated and unsophisticated investors alike.²⁴

C. MPIDs

The proposed rule change also would amend FINRA Rules 6160, 6170, 6480, and 6720 to require each ATS to acquire and use a single, unique MPID for reporting purposes.²⁵ The MPID would be designated for the exclusive use of the ATS, and a firm would not be permitted to use multiple MPIDs for a single ATS.²⁶ Any reporting by the ATS (including reporting to the Order Audit Trail System, to a FINRA Trade Reporting Facility, to FINRA’s Alternative Display Facility, the OTC Reporting Facility, or the Trade Reporting and Compliance Engine) would have to reflect the ATS’s assigned MPID.²⁷  

As Richard Ketchum, FINRA’s Chairman and CEO, has explained, these new requirements “will allow FINRA to monitor the trading that occurs in each ATS much more particularly,” and “to identify if any abusive trading appears to occur with respect to any activity in any ATS.”²⁸ Additionally, according to Mr. Ketchum, FINRA will compare the trade reporting data to the data self-reported to FINRA by the ATSs to verify its consistency and accuracy.²⁹

D. Relevant Timeline

According to the proposal, the effective date for the ATS reporting requirement is to be no later than 90 days following publication of the Regulatory Notice announcing the SEC’s approval, whereas the effective date for the MPID requirement is to be no later than 270 days following such publication.³⁰ It is of course possible that the SEC could delay the effective dates, should firms report implementation issues.

Conclusion

By increasing transparency over dark pools, FINRA’s proposal could improve market integrity (through FINRA’s improved surveillance capabilities) and increase competition (relative to stock prices, through the improved quality of the information made public). At the same time, FINRA has tempered the scope and timing of the information it plans to make public, suggesting that FINRA appreciates the contribution dark pools make to market integrity (by disabling predatory traders and preventing large market movements) and competition (among individual markets). If the proposal is approved, it will be important for FINRA to continue to proceed cautiously, and to monitor whether adjustments should be made to the timing and scope of information made public, so as to optimize market efficiency.

What is almost certain is that FINRA’s improved surveillance capabilities will lead to increased disciplinary actions relating to Regulation ATS violations. ATSs should review their compliance with Regulation ATS in the near-term, as well take steps to ensure appropriate progress is being made on their build-outs relative to the proposed MPID requirement.

The comment period for the proposal expires on November 12, 2013.³¹ FINRA has specifically requested comments on the benefits and burdens of future expansion of the proposal to require trade information reporting for other over-the-counter executions of FINRA broker-dealers separate from ATS trade information, and on making such information public, in the same manner as is proposed for ATS trade information.³² Impacted entities should comment accordingly.

¹ Proposed Rule to Require Alternative Trading Systems to Report Volume Information to FINRA and Use Unique Market Participant Identifiers, SR-FINRA-2013-042 (“Proposal”), available at http://www.finra.org/web/groups/industry/@ip/@reg/@rulfil/documents/rulefilings/p354143.pdf; Notice of Filing of Proposed Rule Change To Require Alternative Trading Systems To Report Volume Information to FINRA and Use Unique Market Participant Identifiers, 78 Fed. Reg. 62862 (Oct. 22, 2013) (“Notice of Proposed Rule Change”); Update: FINRA Board of Governors Meeting at 1 (July 11, 2013) (noting that the FINRA Board of Governors authorized FINRA to file with the SEC such a proposal). Dark pools allow subscribers to trade publicly listed securities without use of public exchanges, without pre-trade disclosure of “indications of interest” (the dark pool equivalent of bids or offers), and without the need to ever disclose the identity of the trading party. Electronic communications networks are computer systems that also allow subscribers (or parties with a brokerage account providing direct access trading) to trade off-exchange, although they have increasingly adopted an open book format, displaying quotations in NMS stocks in the national market system.

² Proposal, supra note 1 at 6.

³17 C.F.R. §242 et seq.

⁴ Regulation ATS defines an ATS as:

any organization, association, person, group of persons, or system: (1) That constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange within the meaning of [Exchange Act Rule 3b-16]; and (2) That does not: (i) Set rules governing the conduct of subscribers other than the conduct of such subscribers’ trading on such organization, association, person, group of persons, or system; or (ii) Discipline subscribers other than by exclusion from trading.

17 C.F.R. §242.300(a).

⁵ 17 C.F.R. §242.301(b)(1) (broker-dealer registration requirement).

⁶ 17 C.F.R. §242.301(b)(5)(i)-(ii). The fair execution access requirement applies to “NMS stock,” as defined in Rule 300(g) of Regulation ATS, and to other types of securities, including certain unlisted equity securities, municipal securities, and corporate debt securities. 17 C.F.R. §242.300(g); 17 C.F.R. §242.301(b)(5)(iii).

⁷ Laura Tuttle, Alternative Trading Systems: Description of ATS Trading in National Market System Stocks, at 2 (Oct. 2013), available at http://www.sec.gov/marketstructure/research/ats_data_paper_october_2013.pdf.

⁸ Proposal, supra note 1 at 5-6.

⁹ Id.

¹⁰ Id. at 6.

¹¹ Id. at 14.

¹² FINRA’s rule proposal applies to any ATS, as that term is defined in Regulation ATS, which has filed a Form ATS with the Commission. Id. at 4, n.2. See also, Release No. 34-40760, Regulation of Exchanges and Alternative Trading Systems, available at http://www.sec.gov/rules/final/34-40760.txt (providing details on off-exchange trading venues that are excluded from Regulation ATS requirements).

¹³ Proposal, supra note 1 at 6. Thus, the reporting requirement would apply to any NMS stock, OTC Equity Security, or debt security subject to FINRA’s Trade Reporting and Compliance Engine rules. Id. at 6-7. Proposed Rule 4552 does not require ATSs to report trade information concerning municipal securities.

¹⁴ Id. at 7.

¹⁵ Id. at 7-8.

¹⁶ Id. at 3.

¹⁷ Id. at 10.

¹⁸ Id. at 8-9; See also, Plan to Address Extraordinary Market Volatility Submitted To The Securities And Exchange Commission Pursuant to Rule 608 of Regulation NMS Under The Securities Exchange Act of 1934, at Appendix A and Schedule 1 to Appendix A, available at http://www.sec.gov/news/press/2011/2011-84-plan.pdf (defining Tier 1 NMS stocks and specifying the exchange-traded products included within the definition).

¹⁹ Proposal, supra note 1 at 9.

²⁰ Press Release, Securities and Exchange Commission, SEC Launches Market Structure Data and Analysis Website (Oct. 9, 2013), available at https://www.sec.gov/news/press-release/2013-217; Market Structure Data and Analysis Website, available at www.sec.gov/marketstructure. The SEC website also includes SEC staff research papers and analysis, including one paper using order audit trail data on off-exchange trading to provide metrics describing the underlying nature of off-exchange trading by the fourty-four ATSs that trade equity securities. The primary observation of the SEC staff is that ATS trading looks very similar in many respects to exchange trading. Another paper summarizes current studies that address market fragmentation — both visible and dark. Id.

²¹ Press Release, supra note 20.

²² Id.
 
²³ Id.

²⁴ Separately, FINRA has signaled that it is very much focused on using technology, and the data it is able to generate, to help it examine firms and regulate the markets.  See FINRA Chairman and CEO Richard Ketchum, SIFMA C&L New York Regional Seminar (Oct. 28, 2013), available at https://www.finra.org/media-center/speeches-testimony/remarks-sifma-cl-new-york-regional-seminar (specifying the various ways FINRA presently uses technology to mine data as well as its future plans).

²⁵ Proposal, supra note 1 at 3.

²⁶ Id. at 11 and 14.

²⁷ Id. at 14.

²⁸ FINRA Chairman and CEO Richard Ketchum and Lead Governor Jack Brennan, July 2013 Board Update (July 11, 2013), available at https://www.finra.org/about/governance/finra-board-governors/meetings/2013-july.

²⁹ Id.

³⁰ Proposal, supra note 1 at 3.

³¹ Id. at 39; Notice of Proposed Rule Change, supra note 1 at 62866.

³² Proposal, supra note 1 at 17.