Views on improving the integrity of global capital markets
19 November 2012

Dark Trading: Is It Hurting Market Quality?

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.

One-of-a-Kind Study
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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Photo credit: ©

About the Author(s)
Rhodri Preece, CFA

Rhodri Preece, CFA, is Senior Head of Industry Research for CFA Institute. He is responsible for building and maintaining the global research function at CFA Institute, including leading the planning, coordination, and creation of research content across CFA Institute research platforms, which include the Future of Finance, the CFA Institute Research Foundation, the Financial Analysts Journal, and the Enterprising Investor blog. Preece formerly served as head of capital markets policy EMEA at CFA Institute, where he was responsible for leading capital markets policy activities in the Europe, Middle East, and Africa region. Preece is a former member (2014-2018) of the Group of Economic Advisers of the European Securities and Markets Authority (ESMA) Committee on Economic and Markets Analysis. Prior to joining CFA Institute, Preece was a manager at PricewaterhouseCoopers LLP where he specialized in investment funds.

14 thoughts on “Dark Trading: Is It Hurting Market Quality?”

  1. Steven Boyd says:

    Dark pool trading should not be permitted in publicly traded stocks without immediate disclosure of price and size. To allow such is to disadvantage individual investors based on lot size. The CFA institute should take a stronger stance against this.

  2. Ben says:

    @Steven All dark pool trades go to tape.

  3. The article misses the most important question: why does dark tradfing exist? Regulators have been killing the liquidity of markets by killing the brokerage industry with high costs. The number of small, independent investment banks has been dramatically reduced.

    I agree with the others: Trading away from public exchanges should be reported. But that doesn’t get to the root cause.

  4. Bruce Sansom says:

    It is said that if you have to cover your face, you are engaging in poor behaviour. I’m an old guy, in the investment business for over 58 years. Dark pools exist because lit markets are failing investors. It’s appauling that the NYSE is fined $5 million for engaging in favoritism and nobody cares.The High Frequency gang and ETF activity have pushed aside the interests of the legitimate investor. Investors aren’t stupid. They are fleeing the markets and we so called “professionals” are watching our own demise right before our eyes. The Regulators are getting ever more aggresssive at fighting a rear guard action to control conflict and dishonest activities. All investors, large and small, are simply being victimized and those with influence appear intimidated.

  5. Mario Eichenberger says:

    dark pools are not that bad per se, but obscurity opens doors for malpractices and definitely does not help improve long lost trust. it’s all about equal level playing fields. be it an institutional or private investor sufficiently aware of and experienced in trade execution, he does not want to show his trade when he knows that some privileged ‘liquidity’ provider can squeeze himself in in a fraction of a millisecond and a fraction of a cent. stock exchanges (or better their executives) which allow ‘certain’ clients faster access to the order book and more economic execution over others (in terms of price setting) are killing their own business. this practice I would certainly not call ‘sustainable’, and it provides to a general feeling of ‘a market played with loaded dice’. last word on the study which concludes with no surprise though ‘good to have a quantitatively founded proof’: dark pools can only work well with meaningful market price information. as liquidity dries up in ‘visible’ markets, participants in dark pools also find it more difficult to find efficient pricing. i am certainly not a big fan of governmental institutions, but our industry – unfortunately – has proven over and over again that private market mechanisms are prone to fail (not least ethically) when they are absolutely not meant to. maybe the time is right to think about a supranational market place sponsored by a ‘Worldbank’ and governed/supervised by IOSCO, where liquidity is not anymore ridiculed by a dozen or more different market places (good old arbitrage gone…). local exchanges would still be needed to cover mid-and small-caps. after more than 30 years in the industry I know this idea will not fly – not for its value, but for all the economic and political interests interwoven – maybe more people will start to live the latin way and spend right away what they (have) earn(ed) – that might alleviate headaches of how and where to invest, but unfortunately drive a good part of our (for its fundamental function: noble) industry out of business…

  6. Rhodri Preece, CFA says:

    Thanks for all your comments. I think there are two important issues here. The first is that there should be full post-trade transparency of all trades, whether executed in lit or dark markets. In that respect, the U.S. markets fare very well, because all trades are immediately reported to the consolidated tape. That contrasts with, for example, Europe, where there is no comparable consolidated tape and (as yet) a lack of consistency in trade reporting practices. The second issue is the economics of the exchange industry itself. The switch from mutually-owned exchanges to for-profit enterprises, along with the adoption of fully electronic markets, fragmented liquidity, and dwindling volumes, lies behind the expansion of HFT and the diversification of exchange business lines. Speed, scale, and market data revenues are key drivers of profitability. Although trading costs have clearly fallen, it is legitimate to ask how well the for-profit model serves different types of investors.

  7. Dan says:

    This is my opinion. Having been a proprietary trader for the past 8 years I can say, based on my experience, that dark pools don’t hurt liquidity but they do hurt true price discovery. They also allow for manipulation by HFT and predatory algo’s by certain firms especially the ones with deeper pockets. This is all part of a larger problem that is commingled with co-location and order routing. The playing field is no longer fair.

    The CFA stance is basically a non-stance. If you wait and see – it will be too late.

    1. Roger Lindsley says:


  8. neilcrammond says:

    “fair and orderly markets !”
    exchanges and regulators are obliged to provide these markets however “dark pools have been created as they appear to be above the law ; current regulation running approx 3 years behind curve .
    I predict “dark pools ” to be far more dangerous and destructive than HFT ; i am
    quite amazed who ever made them legal !
    How can a trader “cross” 100% of his order internally be legal ? Yet again the retail trader gets a raw deal ; dark pools allow total manipulation and abuse .

  9. Rhodri Preece, CFA says:

    Functionally similar trading venues – exchanges and “exchange-like” dark pools – should be regulated the same way. Retail investors have seen both spreads and commissions come down. But if all the retail flow is internalized, it could have adverse consequences for market quality in the long run if investors become disincentivized from using the public markets.

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  12. Henk says:

    As a dealer in a market where the exchange allows Dark Trading at worse pricing than the lit market, I am astounded that the CFA stance is not stronger. I cannot for the life of me see how participants can be allowed to bypass the lit market and leave all the lit orders unmet.
    In my view, the move to Dark pools is a reaction to HFT, and an effort by vested interest to protect their margins.

  13. Rhodri Preece, CFA says:

    Thanks for your comment. The issue of unfilled displayed orders could discourage investors from using the public markets, especially if those orders are adversely selected against. Segmentation of orders in dark markets can have this effect. That said, dark trading should generally provide price improvement. Ensuring that there is a healthy balance between dark trading and the lit markets – which provide the price discovery that the dark markets use for reference – is essential.

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