Over the past decade, the trend toward larger volumes of equity-market transactions taking place away from public exchanges has led to concerns about investor access and competition with the traditional exchanges. In response, CFA Institute has published Dark Pools, Internalization, and Equity Market Quality.
There were three primary motivations for the report, which examines “internalization” — internal execution of client orders within a broker/dealer system or against the broker’s own account — and so-called “dark pools,” a type of alternative trading system:
- With the volume of dark liquidity growing by nearly 50% over the past three years to account for nearly a third of consolidated volume, there is a clear shift in the market structure away from trading on transparent exchanges and towards dark, or undisplayed venues. A primary example: the launch of the New York Stock Exchange’s Retail Liquidity Program (RLP), which went into operation in August. Under the RLP, retail orders sent to the NYSE will execute against undisplayed retail price improvement orders residing within the exchange system — effectively a type of dark pool for retail investors.
- Members of our Capital Markets Policy Council (who provide practical expertise and industry perspective on critical issues in the capital markets) have raised concerns that the incentive to display orders in public markets is undermined by certain off-exchange trading practices, such as sub-penny trading in which broker/dealers fill retail orders ahead of displayed limit orders by offering price improvement in fractions of a penny.
- Regulators around the world have voiced concerns over dark trading, including those in the United States, Europe, Canada, and Australia, as well as the International Organization of Securities Commissions (IOSCO). The U.S. Securities and Exchange Commission (SEC) has considered regulatory proposals related to dark liquidity but has not passed any rules to date.
To conduct this study, we selected a sample of 450 U.S. stocks stratified across listing market and market capitalization. For each stock, data on bid-offer spreads, top-of-book depth, off-exchange volumes, and other variables were obtained on a selection of dates over the period from the first quarter of 2009 through the second quarter of 2011.
Off-exchange trades reported to the NASDAQ Trade Reporting Facility, which account for approximately 95% of all off-exchange trading, were sub-categorized into dark pools, internalization, or other OTC trading. This was performed by NASDAQ using information on the identity of the party reporting a given trade. Only aggregate off-exchange data is otherwise available; to the best of our knowledge, there are no other studies that look at dis-aggregated data on dark trading volumes in this manner.
To analyse the relationship between dark trading and market quality, bid-offer spreads and top-of-book depth (the dependent variables of interest) were regressed on internalization and dark pool volumes and other explanatory variables. The results show that, after controlling for factors known to affect spreads and depth, increases in internalization and dark pool trading activity are initially associated with declining bid-offer spreads and increasing depth — that is, improving market quality. However, the relationship is not linear; beyond a certain threshold, it reverses. In other words, market quality initially improves but then declines as dark trading increases. We conservatively estimate that when a majority (>50%) of trading in a stock occurs in undisplayed venues, market quality deteriorates.
CFA Institute Recommendations
Although a wholesale revision of the market structure regulatory framework is not necessary, certain improvements are needed. Our analysis suggests that market quality is best served by maintaining strong competition between trading on lit and dark venues, and avoiding a predominance of dark trading, so policy measures should be designed to encourage such an outcome. Our specific recommendations:
- Internalization of retail orders should be required to offer meaningful price improvement, thereby generating economically meaningful savings for retail investors, and providing some protection to investors posting displayed orders in limit order books.
- Regulators should monitor the growth in dark trading and take appropriate measures if it grows excessively.
- Dark trading facilities should improve reporting and disclosures around their operations to enable investors and regulators to make more informed decisions over their use.
We believe that implementation of these considerations would help protect displayed orders while offering meaningful savings to retail investors executing away from public markets, maintain competition, and improve transparency. More fundamentally, these measures would enhance market integrity and lead to greater investor confidence in the equity market structure.
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