What Early Results on Australian and Canadian Trade-at Rules Mean for Regulation
In a previous blog post, I described how increasing internalization of purchased retail order flow, combined with high-frequency trading algorithms, can disincentivise the posting of limit orders on visible exchanges by increasing the costs of adverse selection.
To entice these limit orders back onto lit exchanges, some regulators have introduced “trade-at” rules, which are meant to limit the ability of firms to cheaply internalize uninformed order flow. These rules require higher, economically significant price improvement before orders can be executed in the dark.
In this blog post, I will discuss the results of a CFA Institute-sponsored study, conducted by Sean Foley of the University of Sydney, and Tālis J. Putniņš of the University of Technology Sydney and Stockholm School of Economics in Riga, that examines whether these attempts have been successful.
Canadian regulators introduced a trade-at rule in October 2012, followed by Australia in May 2013. In both countries, the essence of the rule is that dark trades below block size must have at least one full tick of price improvement; half a tick is the minimum price improvement required for stocks priced at less than $1.
Although the Canadian market has had a price improvement rule on the Toronto Stock Exchange since 1998, the 2012 version was broader in scope and intended to reduce off-exchange trading. The CFA Institute-sponsored study finds that, after the implementation of the new trade-at rule, dark trading volume declined by approximately 20% while dark internalization as a proportion of dark trading decreased by more than half. However, the study does not find any evidence that the rule increased the likelihood of investors posting liquidity in the lit markets. Further, quoted and effective spreads increased after introduction of the rule.
The impact on spreads is consistent with CFA Institute research findings on dark pools, internalization, and equity market quality. That study finds that low levels of dark trading improve market quality and, in particular, lower spreads. These positive effects decrease, and ultimately reverse, with higher and higher levels of dark trading. It is possible that the Canadian market experiences dark trading at a level where its impact on market quality is still positive. This is consistent with the latest study finding that the dark trade-reducing trade-at rule resulted in higher spreads.
Finally, with most dark trading happening in liquid stocks with spreads of only one tick, the Canadian rule forced almost all dark trades to execute at the midpoint (since one tick price improvement is not possible with a spread of one tick).
In Australia, the results were similar, with dark trading volume falling by approximately one-third and dark internalization, as a proportion of dark volume, decreasing by two-thirds. However, spreads widened, with quoted spreads increasing by approximately 19%. As in Canada, the majority of dark trades subsequently execute at the midpoint.
The study concludes that the interaction of the trade-at rules with minimum tick-size regulations produces these mixed results with dark trading falling (good) but spreads widening (bad). A possible solution proposed by the authors of the CFA Institute-sponsored study is to decrease the tick size so that price improvement could be offered even on the most liquid stocks. This recommendation should be of interest to the SEC, which in June 2014 announced a pilot program to examine the effects of increasing tick size. Increasing tick sizes is one way of aggregating liquidity around fewer price increments in the order book, in essence partially reversing the effects of decimalization.
Based on the study, CFA Institute offers the following policy recommendations:
- All functionally equivalent trading venues should be subject to functionally equivalent regulation, including requirements regarding access to markets, pre- and post-trade transparency, and the fair treatment of orders. Exceptions to this principle should be allowed in cases where a venue differentiates itself according to the type or size of orders it handles and the existence or otherwise of discretion in order execution.
- Regulators should specifically disallow retail internalization without meaningful price improvement of at least one tick, or half of a tick for securities priced below one primary currency unit (i.e., euro, dollar, franc, etc.).
- Regulators should continue to monitor the growth in dark trading volume and internationalization, in particular, and consider restrictions on dark orders and dark trading facilities should the magnitude of dark trading volume reach a significant level. A possible measure would be to lower the threshold at which alternative trading systems must display orders and meet general access requirements for particular stocks.
- Regulators and trading venues should improve reporting and disclosure around the operations of dark trading facilities and internalization pools, including the types of orders that are accepted within those systems and the processes by which orders are matched. Dark trading facilities should voluntarily reveal greater information about their operating mechanics and report more information on the volumes they execute as a means of improving transparency and enabling all stakeholders to better understand their relative benefits and drawbacks. The goal of these changes should be to enhance investor trust by protecting displayed orders while offering meaningful savings to retail investors executing away from public markets, maintaining competition, and furthering transparency.
If you liked this post, consider subscribing to Market Integrity Insights.
Photo credit: iStockphoto.com/RomoloTavani