A study of dark trading in non-displayed equity market venues shows the impact is initially associated with improving market quality in terms of bid-offer spreads and market depth. But, when a majority of trading in a stock occurs in dark pools and through broker-dealer internalization, market quality deteriorates, according to the CFA Institute, a global association of investment professionals.
"Dark Pools, Internalization and Equity Quality," published today, was conducted as larger volumes of equity-market transactions take place away from public exchanges. At the same time, concerns about transparency, investor access and competition with traditional exchanges have been raised.
Based on the results, CFA Institute is recommending three public policy measures to support fair competition and protect investors who display quotes in the public markets. The specific recommendations include:
• 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 on public exchanges.
• Regulators should monitor the growth in dark trading and take appropriate measures if it grows excessively.
• Dark trading facilities should voluntarily improve reporting and disclosures around their operations to enable investors and regulators to make more informed decisions over their use.
To conduct the study, a sample of 450 U.S. stocks stratified across listing market and market capitalization was selected by CFA Institute. For each stock, data on bid-offer spreads, top of book depth, off exchange volumes and other variables were obtained on a selection of data were obtained from the first quarter of 2009 through the Q2 of 2011. The Institute then looked at off-exchange trades reported to the FINRA/Nasdaq Trading Reporting Facility (TTF). While only aggregate off-exchange data is available, CFA Institute said there are no other studies that look at disaggregated data in this way.
The results show that after controlling for factors that are known to affect spreads and depth, increases in internalization and dark pool trading activity are associated with declining bid-offer spreads and increasing depth. However, beyond a certain threshold, market quality declines as dark trading increases. CFT Institute estimates that when more than 50% of trading in a stock occurs in undisplayed venues, market quality deteriorates.
There were several motivations for undertaking the study:
• The volume of dark liquidity has grown by nearly 50% over the past three years to account for nearly a third of consolidated volume in the United States. With similar trends in Europe, there is a clear shift in the market structure away from trading on transparent exchanges and towards dark, or undisplayed venues. For example, it cites that the New York Stock Exchange's Retail Liquidity Program (RLP) as an example of an undisplayed trading system for retail orders.
• Regulators around the world have voice concerns about dark trading, including those in the U.S., Europe, Canada, and Australia, as well as the Organization of Securities Commissions (IOSCO). The SEC has considered proposals related to dark trading but has not passed any rules to date.
• Members of the CFA Institute Capital Markets Policy Council have raised concerns that the incentive to display orders in public markets is undermined by certain off-exchange trading practices, such as sub-penny pricing, in which broker/dealers fill retail orders ahead of displayed limit orders by offering price improvement in fractions of a penny.