Canada Assesses Dark Liquidity

Terry Flanagan

Too much dark liquidity in financial markets can impair transparency and price discovery. Too little dark liquidity can leave large block trades vulnerable to information leakage and inefficient execution.

What is the optimal level of dark liquidity? As would be expected, opinions vary widely among market participants, market operators, and regulators.

Rule-making regimes worldwide are working to understand dark liquidity and its impact on markets, and craft new rules as warranted. While regulators in the U.S. are studying the issue, Canada took action last fall, implementing a system designed to limit dark liquidity.

The jury is still out on the Canadian rules, but early indications are positive that the nation has at least taken a proactive approach and may be one step closer to a feasible solution.

“They’re trying something rather than just sitting back and wringing hands,” said a Canadian regulatory expert, who spoke on condition of anonymity.

In October 2012, the Canadian Securities Administrators and the Investment Industry Regulatory Organization of Canada implemented rules governing dark liquidity. Key aspects to the regulation include visible order priority, meaningful price improvement, and minimum size.

Six months later, there are ongoing studies to determine the market impact of the new rules and it’s difficult to draw any firm conclusions yet, according to the regulatory expert.

“There seems to be less price improvement going to retail clients, but that was always small,” the person said. “The biggest loser may be retail brokers, who are paying more in fees.”

High-frequency market makers may be another constituency that’s benefiting, while brokers who internalize order flow lose business.

Since the new rules were implemented, TriAct’s Match Now has seen market share decline by as much as 30%, while Liquidnet has held steady. “The rules really affected small-sized dark, as opposed to block dark.”

To be sure, the stakes are considerably larger in the U.S., where dark trading has crept up to more than one-third of equity trading volume according to some estimates, or more than 10 times the proportion in Canada. But a successful dark-trading regulatory model in Canada can be transported elsewhere.

“Canada is taking a leadership position,” the regulatory source said. “They’re trying, measuring to see what happens and whether it’s successful. It’s a scientific approach where you hypothesize, introduce, and then go measure what happens.”

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