Dark Pool Rules Stir Controversy

Terry Flanagan

Rules that mandate that dark pools provide price improvement over prices displayed on the ‘lit’ markets are engendering controversy across the financial spectrum.

Under rules that went into effect in Canada last October, operators of alternative trading systems (ATSs) must provide “meaningful price improvement”, meaning that in order to trade with a dark order, smaller orders must receive a minimum level of price improvement, defined as one trading increment or half a trading increment for securities with a bid-ask spread of one trading increment.

Often compared to the proposed trade-at rule in the U.S. markets, the idea is to prevent dark orders from jumping in front of visible quotes by some fraction of a tick, and potentially de-incentivizing investors from placing visible bids and offers in the lit market.

The issue is closely related to the advent of high-frequency trading and its associated reduction of order sizes and bid-ask spreads.

“High-frequency trading has shrunk average trade sizes, which is another dimension to the problem,” said Steve Grob, director of strategy at Fidessa, a trading technology firm. “The problem is so bad that some buy-side traders are saying its affecting portfolio performance because they can’t execute large blocks of orders.”

In the U.S., regulators are studying the trade-at rule, which would co-exist with the already established ‘trade-through’ rule, which prevents public exchanges from ignoring, or trading through, a better price that’s listed on an ATS.

“The proposal would expand the trade through rule to a trade-at rule, which would require dark pools to provide meaningful price improvement over public quotes,” said Richard Johnson, head of quantitative services, Americas, at Societe Generale.

Operators of dark pools objected strenuously to the proposed minimum price improvement requirement.

“Trade-at is very controversial in Canada, where one dark pool saw its market share go from 3.5% to 0.5%,” Johnson said.

The framework, which involved amendments to National Instrument 21-101 Marketplace Operation and to the Universal Market Integrity Rules, was approved by the Canadian Securities Administrators (CSA) last March.

In addition to meaningful price improvement, the framework stipulates that visible orders have execution priority over dark orders on the same marketplace at the same price, and that regulators have the ability to designate a minimum size for dark orders.

Dark pools and transparent marketplaces that permit dark orders or icebergs with less than one standard trading unit being displayed will be required to ensure that their trading system functionality provides execution priority for visible orders on their marketplace over dark orders on their marketplace at the same price.

Both the CSA and the Investment Industry Regulatory Organization of Canada (IIROC), the national self-regulatory organization which oversees all investment dealers and trading activity on debt and equity marketplaces in Canada, are monitoring market developments to consider whether and when IIROC should implement a minimum size.

The framework recognizes the increasing use of dark liquidity and balances displayed and dark liquidity for healthy price discovery, and is intended to ensure Canadian equity markets continue to evolve in a fair and competitive manner that strengthens market integrity and investor protection, according to regulators.

The initiative, which followed extensive consultations with the industry and stakeholders that began in 2009, is designed to enable institutional traders to continue to execute large orders with minimal market impact, while ensuring that investors with smaller orders receive meaningful price improvement when they trade with dark orders.

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