Dark Pools See Shades of Gray

Terry Flanagan

Operators of alternative trading systems say that proposed Canadian pre-trade transparency regulations ignore the impact of advances in trading technology.

“I don’t think the proposed rule appreciates how the industry has changed in the past ten years with the reliance on smart-order routing and increased use of algorithmic trading,” said Torstein Braaten, CEO and chief compliance officer of TriAct Match Now, ITG’s Canadian dark pool. “Both have decreased the order sizes being sent to marketplaces and also decreased fill sizes in both lit and dark venues.”

The Canadian Securities Administrators (CSA) and Investment Industry Regulatory Associations of Canada (IIROC) have jointly issued proposals for pre-trade transparency, including a minimum size threshold, price improvement for orders executed on a dark pool against orders on a displayed market, and priority of execution for visible orders over dark orders at the same price on the same marketplace.

“These rules discourage the integration of dark and light on one venue, i.e. hidden orders will lose prominence because of the required price improvement to trade with smaller sized light orders,” said Alison Crosthwait, managing director of global market structure research at Instinet. “These rules also mean that dark trading will be focused on larger-sized orders rather than the small sizes seen today.”

The concerns aren’t limited to Canada: U.S. regulators are mulling whether to require dark pools to provide price imporvement over lit orders, via a so-called trade-at rule.

“The Securities and Exchange Commission appears to be seriously considering the trade-at rule,” Braaten said.” I suspect that they do not appreciate the unintended consequences that would result with such a rule if it also requires a full price increment improvement, as proposed by the Canadian regulators.”

The paradox is that block-size institutional orders often get chopped up into smaller ones, which would preclude their being executed on dark pools.

“The industry will continue to increase their use of algorithms that slice up larger orders to seek liquidity and best execution,” said Braaten. “A larger order at a broker dealer that may be considered sufficiently large in the regulators eyes to qualify for a dark venue is often broken up, with only a piece of that order being sent at one time to a dark pool or as a dark order on a lit market.”

Regulators need to make more of an effort to understand how the industry is using dark pools and dark orders, said Braaten. “The main concern we have is that with market fragmentation and volatility it will continue to be more prevalent to see orders broken up and distributed across multiple venues,” he said.

With regard to price improvement, the proposal seems to be focused on ensuring that a passive limit order gets traded ahead of any dark orders, which could result in discouraging liquidity providers from posting dark orders that may be price and execution cost sensitive.

Another concern is that the proposed regulations would provide a business advantage to lit venues for dark liquidity (i.e. dark orders) that compete against dark pools that are not protected markets.

“In particular, dark pools cannot leverage two trading books–dark and lit–by offering both in the same protected marketplace,” said Braaten. “We believe that there is value to keeping the dark venues separate and hope that regulators through their policies will continue to support the innovation that they provide. There needs to be an even playing field across all business models while still appreciating that everything does not need to be the same.”

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