Regulators Shed Light on Dark Pools

Terry Flanagan

Australian regulators have issued regulations concerning dark pools, while at the same time a study by an Australian research firm has found that low levels of dark trding improve market quality.

The Australian Securities and Investments Commission has released market integrity rules on dark liquidity and high-frequency trading, as well as guidance on the rules which clarifies ASIC’s expectations of market operators and participants.

“We expect the new rules will quickly lead to changes in the behavior of market participants, building on the positive changes we have already seen with other recent rule changes and the work of ASIC’s taskforces on dark liquidity and high frequency trading,” said ASIC Commissioner Cathie Armour. “For example, there has been a significant decline in the volume of dark liquidity (below block size) as a result of the meaningful price improvement rule introduced in May this year, and we have observed a considerable drop in small and fleeting orders.”

Meanwhile, a study conducted by Capital Markets Cooperative Research Centre (CMCRC) has found that low levels of dark trading improve market quality.

The study, by Sean Foley, CMCRC research analyst, and Talis Putnins of UTS, analyzed Canadian dark trading before and after the introduction of minimum price improvement rules in October 2012. Their findings indicate that the low levels of dark trading observed in Canada reduce transaction costs and improve the efficiency of the market.

“The Canadian rules reduced the amount of dark trading in Canada by one-third, literally overnight,” Foley said. “We exploited this natural experiment to examine the effects of continuous (non-block) dark trading on the market using a number of models which controlled for other factors such as traded volume and volatility. Rigorous testing of the data consistently showed that dark trading at the level observed in Canada is a positive force for market quality and efficiency.”

The study showed that dark trading at relatively low levels – 10% in Canada prior to the introduction of the rules increase the efficiency of lit markets by lowering quoted, effective and realized spreads, reducing price impact measures of illiquidity, making prices closer to the random walk process that would be expected given an efficient market, reducing the variance of midquote returns and reducing the delay with which stock prices reflect market-wide information.

The study supports findings in a previous CMCRC study suggesting that intra-day dark trading is associated with reduced spreads and volatility and increased depth and traded volume.

“We found that dark trading is beneficial in moderation,” Foley adds. “At the levels observed in Canada, which are below the indicative 10% tipping point found using Australian data, dark pools have a valuable niche in financial markets.”

Canada was the first market to introduce such rules, and similar rules were introduced in Australia in May 2013. Dark trading in Australia was reported by ASIC to be around 17% of dollar volume up until May this year. However, ASIC’s recent rule changes have reduced this by up to 40% according to some estimates. “We haven’t looked specifically at Australia, but this study’s results could be extrapolated to suggest that the regulation could be positive for the local market if it prevents dark trading from increasing to a point where it becomes detrimental,” Foley said.

Future studies should examine the exact tipping point at which dark trading changes from beneficial to harmful, the determinants of such a change, and how this varies between markets. “As more regulators look to implement rule changes around dark pools, there will be ample opportunity to study these effects,” Foley said. “It’s my hope that studies such as this will provide valuable evidence so that regulations can be made on an informed, rather than arbitrary, basis.”

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