Zero Hedge has been the subject of much (welcome) ridicule both retail and institutional, for continuing the barrage of Indication of Interest screens (also: IOIA tag) and information for the benefit of our readers, which I have been showing consistently over the past month, ever since I had a feeling there is something peculiar in the advertised trade flow pipes. It never hurts to be proven right.
Today, the top trading chief of the Securities and Exchange Commission, James Brigagliano, announced that not only will dark liquidity pools (another topic Zero Hedge has discussed skeptically in the past specifically in the context of liquidity) become the focus of a much broader SEC focus (about time), but also automated Indication of Interest notifications have become "a potential source of concern for regulators."
The plot thickens
From the article:
James Brigagliano, co-acting director of the SEC's Division of Trading and Markets, said dark pools could impair price discovery by drawing valuable order flow away from the public quoting markets. "To the extent that desirable order flow is diverted from the public markets, it potentially could adversely affect the execution quality of those market participants who display their orders in the public markets," he said. Brigagliano added that anything that "significantly detracts from the incentives to display liquidity in the public markets could decrease that liquidity and, in turn, harm price discovery and worsen short-term volatility."
Brigagliano also took aim at dark-pool volume-reporting practices. "I'd like to give you specific statistics on the trading volume [of dark pools]," he told the crowd, "but there's very little reliable public information on dark-pool trading activity."
The SEC exec noted that some dark pools publish monthly volume figures, but that the lack of uniform reporting standards makes those figures less reliable. Some pools, he said, count both the buy and sell sides of a trade while others single-count their volume. In addition, some pools include "touched" orders in their volume stats rather than just matched trades.
In addition to concerns about price discovery and accurate trade reporting, Brigagliano targeted indications of interest sent between dark pools as another potential concern for regulators. These automated IOI messages, which usually are executable and for small size, are sent to seek liquidity from other dark pools to increase the original pool's executions. The widespread use of these "actionable order messages could create the potential for significant private markets to develop that exclude public investors," Brigagliano said. He added that these actionable order messages could affect competition among trading centers and contribute to market fragmentation by making consolidation efforts among dark pools less likely.
While the Indications of Interest screens Zero Hedge provides focus on regular markets, not dark pools, they still serve a critical purpose of providing an insider network the same "liquidity needed" signals that dark pool IOIs represent. As such, the represent an unfair advantage to buy siders who possess the advantage of seeing who may or may not be advertising a need or is in the process of accumulating abnormal amounts of stock. And the follow up is that those who keep track of IOIs in index ETFs where lately the bulk of the hedging action has focused due to the persisting HTB nature of numerous financial stocks, savvy buysiders can now extrapolate not only which hedge/quant fund is levering/delevering, but how to generate abnormal profit by further forcing the potential unwind, thereby exacerbating market illiquidity (despite the attempts by SLP providers such as Goldman Sachs to restore it).
Another question arises: which major quant funds tend to trade significantly in the dark pool realm, potentially generating significant price distortions, and why have some of them also recently become the focal point of targeted SEC scrutiny. Is this merely a coincidence?
Just as in the AIG case, Zero Hedge was happy to provide the initial information that led to much additional disclosure (and cable TV melodrama) on the AIG counterparty fiasco, so I hope in this case regulators are catching on to this potentially abusive practice of market efficiency and liquidity. However, even in a world where dark pools and covert IOIs are eliminated (and ITG's business model is destroyed), there is still much more needed before one can even presume we have anything resembling a transparent market. And as long as that is the case, those with the upper informational hand will benefit at the expense of those without.