Tackling the Dark Side in Canada …
In recent weeks, Canadian Securities Administrators (CSA) and the Investment Industry Regulatory Organization of Canada (IIROC) published their regulatory approach to dark liquidity (a.k.a. non-displayed orders) in Canadian equity markets. The announcement came off the back of an earlier consultation examining the impact of dark pools and dark orders on factors such as overall market transparency, quality, and integrity. The message coming from Canadian regulators is clear: the use of dark pools and dark orders should be limited, with priority given to transparent orders. In the wider interests of market integrity, this is a welcome step in the right direction.
The joint CSA/IIROC position statement sets out four main recommendations. Firstly, an exemption from pre-trade transparency requirements (i.e. obligations to display orders) should only be available to orders that meet or exceed a minimum size threshold. This rule would apply across all marketplaces. It is true that restricting the use of dark orders to a certain size threshold may be seen by some as overly stringent. By comparison, the European framework is more flexible in this area. However, given that the primary motive for using dark pools and dark orders has always been to protect investors from market impact, a size threshold is intuitively appealing. Indeed, prima facie, there is little economic justification for sending small orders to a dark pool. But perhaps most importantly, by applying the same pre-trade transparency exemption rule across all marketplaces, no single trading venue should be disadvantaged relative to another. This should help foster a level playing field.
Secondly, the Canadian authorities propose that two dark orders meeting the dark order size threshold should be able to execute at the National Best Bid and Offer (NBBO), but in all other circumstances, dark orders would have to provide ‘meaningful’ price improvement. Thirdly, that meaningful price improvement should be one trading increment (defined as 1 cent, or half a cent for stocks with a price below $0.50). And finally, the authorities recommend that displayed orders should receive execution priority over same-priced dark orders on any given marketplace.
Protecting Displayed Liquidity
Collectively, the second, third, and fourth measures should bolster investors’ willingness to provide displayed liquidity. This is much needed. Indeed, one of the most troublesome aspects of the equity market structure evolution in North America (and to a lesser extent, Europe) has been the disincentive to post displayed limit orders — the essential ingredient of price discovery. This has resulted largely from uneven rules amongst similar types of trading venues and trading activities.
A specific case in point is the issue of ‘sub-penny’ trading. This practice has discouraged investors from submitting passive limit orders because those orders are frequently stepped in front of by off-exchange (dark) transactions that obtain execution priority by offering only nominal price improvement, often in the magnitude of $0.0001 per share. As the joint CSA/IIROC paper points out, “we do not believe that price improvement below one trading increment is meaningful to ensure that the benefit to investors from receiving price improvement outweighs the cost … of lost opportunities to trade because of dark orders offering minimal price improvement ‘jumping the queue’”. In other words, because displayed limit orders are frequently unfilled, there is a disincentive to use them. Moreover, when displayed orders do get filled, it is usually because those orders are on the wrong side of the market. Consequently, investors have very little incentive to display a visible limit order, which in turn can adversely affect market liquidity and public price discovery.
CFA Institute expressed these sentiments in a recent comment letter to IOSCO on market structure issues. The Canadian authorities have taken a bold but welcome step to protect transparent orders and halt the trend towards greater use of dark liquidity by engendering more consistent rules across similar marketplaces. Others should follow.
For more, read a related post: Dark Pools in Asia Pacific — Watch This Space