Get ready for the regulatory debate to heat up regarding
dark pool or nonexchange trading, a practice that currently
represents a third of U.S. equity trading and is generally
viewed as a benefit to institutional investors seeking to
minimize the impact of large block trades, and a possible
uptick in trading costs.
With three dark pools or off-exchange venues in the U.S.
Pipeline, Level ATS and Liquidnet coming under
regulatory fire of late for disclosure issues, questions and
concerns continue to be raised about dark pool practices and
regulatory changes are expected.
Thats the finding of a new TABB Group report entitled
A Spotlight in the Dark: An Inevitable Debate.
Like it or not, we believe the rules surrounding
off-exchange trading in U.S. equities will change; it is only a
matter of time, says Miranda Mizen, a TABB Group analyst,
author of the 18-page report and a former senior vice president
of transaction services at the American Stock Exchange.
Mizen notes that regulators in Canada, Europe, Australia,
Asia and Latin America have proposed or are putting into place
new rules to favor market transparency and consolidation at the
same time that questions are being raised about whether or not
dark or off-exchange trading hinders price discovery. In such
venues, trading is designed to be anonymous and prices are made
public only after trading is done.
The TABB Report comes on the heels of new research conducted
by professor Haoxiang Zhu at the MIT Sloan School of Management
and issued in November Do Dark
Pools Harm Price Discovery? that
concludes that adding a dark pool alongside a traditional,
lit exchange actually tends to improve price
discovery efforts. It is just one of many academic reports on
the topic that analyze the varieties of off-exchange trading,
many of which draw different conclusions and add fuel to the
The TABB report surveys the growth of dark execution,
estimating that 30 to 33 percent of all equity trading in the
U.S. now takes place off-exchange, either in independent dark
pools run by firms such as Liquidnet or off-exchange venues run
by broker-dealers. Currently, Barclays, Credit Suisse, Goldman
Sachs and UBS all operate their own internal dark pools or
off-exchange venues, accounting for an estimated 13 percent of
all equity trading volume in the U.S. and 9 percent in
The report also notes that while the percentage of
off-exchange volume is a sore point for lit exchanges such as
the New York Stock Exchange or Nasdaq, they, in fact, do offer
a variety of order types that result in nondisplayed or dark
execution opportunities as well.
With this trading landscape in mind, Mizen advises that any
future debate should take into consideration broader market
structure issues, including the ways in which on and off
exchanges work cooperatively to benefit users and meet various
Buy-side traders with oversized orders to fill want
sizable fills, natural counterparties and the ability to avoid
being seen, Mizen says. At the same time, she notes that
the quality, fairness and efficiency of the public or lit
markets are brought into question if they are viewed as a
destination of last resort for equity traders.
While she does not purport to have an end solution to the
current concerns, Mizen projects a regulatory focus on issues
such as price discovery, price improvement, trade size and
transparency, as part of the broader market structure
This is in contrast to the the CFA Institute in the U.K.
which states in a report issued in November that as larger
volumes of equity-market transactions take place away from
public or lit exchanges, the way to ensure market quality is by
maintaining strong competition between lit and dark venues.
The CFA report suggests ways to achieve this goal. One is
consistent regulatory monitoring of dark pool activity with
action taken when it grows excessively, or when it accounts for
over 50 percent of equity trading and voluntary reporting
disclosures on the part of dark trading facilities. This, they
argue, will enable investors to make more informed decisions
regarding their use.
We believe that implementation of these considerations
would help protect displayed orders . . . maintain competition,
and improve transparency, said Rhodri Preece, director of
Capital Markets Policy at the CFA. The CFAs suggestions
come at a time when the launch of a dark pool audit and
assessment service to help clarify dark pool practices is being
proposed in the U.S. by consulting firm Woodbine
However, there are three big questions, Mizen of TABB Group
says, that need to be addressed to ensure that any new
regulations have fairly assessed potential impacts on trading
- Does the protected quote need better protection?
- Should criteria around off-exchange trading be
- How can regulators temper the need for dark pool trading
benefits with a call for greater transparency and fairness in
markets? Put another way, How should execution
alternatives dark or off-exchange vs. lit or
exchange-based trading be regulated and yet
still fit together?
The report notes that dark pool formation has its origins in
buy-side demand for better execution and more competition in
trading options. Dark pools have allowed liquidity to be
democratized rather than locked up within a few relationships
and this has resulted in reduced market impact, reduced
explicit costs and price improvement, Mizen says. She
adds that, despite the benefits of dark pools, many market
participants now believe that equity markets have become too
fragmented and opaque and that dark pools are a key contributor
to this problem.
Mizen warns that the longer the SEC waits to establish new
regulations, the more disruptive the impact will be on markets.
She points out that the JOBS Act of 2012 indirectly forces open
one door to change, as the SEC is set to review tick sizes of
smaller companies and will need to consider any change
In conclusion, Mizen says that scrutiny of dark
execution off-exchange must equally scrutinize dark execution
on-exchange, where the complexity of order types and high
frequency trading create a very difficult trading environment.
Trading outside the lit order books offer legitimate value and
advantage . . . To be effective, the dark debate must be part
of the broader market structure debate that includes the
quality and efficiency of the lit markets.