Exchanges Live In Glass Houses

Joe Saluzzi, Sal Arnuk

Themis Trading, July 2, 2013

The head of US Market Regulation for Nasdaq, John Zecca, just published a one page article titled “A Level Playing Field For Surveillance” . In his article, Mr. Zecca is calling for increased surveillance of dark pools. Specifically, Mr. Zecca states:

“To ensure overall market integrity, it is critical to subject all trading venues, including regulated exchanges and dark pools, to the same rigorous transparency and market surveillance standards.

Because ATSs are not obligated to provide FINRA with full information on their order book activity, FINRA does not receive as much data from dark pools and other ATSs as it gets from exchanges. As a result, there are opportunities to enhance FINRA’s surveillance of these market centers.

Exchanges must file their operating rules with the SEC, but dark pools only have to provide a description of their order handling process, their customer base and their subscriber requirements.

Most regulators agree that the quality of surveillance cannot vary by venue. Transparency and complete information aggregated across markets is the best remedy to protect investors.“

Considering that almost 40% of stocks trade off exchange, we agree with most of what Mr. Zecca calls for in his article. But at the same time, we can’t help but wonder if the rise of dark pool trading was actually caused by the stock exchanges themselves. Many institutional investors are frustrated by the games that currently go on at the exchanges. They are frustrated by the constant penny jumping and flickering quotes that do not provide any real liquidity. They are frustrated by the endless amount of fee changes that exchanges file for to encourage rebate arbitrage in the hopes of increasing their market share. They are frustrated by the seemingly unlimited order type combinations which allow for queue jumping. They are frustrated that information on their own orders is being packaged and sold in exchange proprietary data feeds to HFT traders.

To make matters worse, institutional investors feel that they can’t trust the exchanges. And why should they. Within the last year, three exchanges have been fined over $20 million by the SEC for regulatory infractions. Rather than seeing exchanges as protectors of their order flow, institutional investors now fear information on their order flow is being leaked by the exchanges.

Is it any wonder that institutional investors have turned to dark pools as a way to try to protect their order flow?

While we agree with Mr. Zecca and Nasdaq that more surveillance is necessary for dark pools, we also think that their words would carry much more weight if they lead by example and stopped some of the shenanigans that have been going on at the lit venues. Otherwise, as the old saying goes, people in glass houses shouldn’t throw stones.

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