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Orchestral manoeuvres in the dark

Published in Automated Trader Magazine Issue 35 Winter 2015

New research findings suggest that US trading rules may be providing dark venues a regulatory advantage over traditional stock exchanges by allowing some traders to circumvent time priority. There's also some cynicism over whether the need to hide large block trades is overhyped amid calls for implementation of a "Trade At Rule". Europe, meanwhile, has its own dynamic, with major exchanges like the LSE starting buy side-only order types in its dark pool. Peter Barker reports.

Amy Kwan, Author and Researcher, Capital Markets Cooperative Research Centre

A recent report from the Capital Markets Cooperative Research Centre has found that US dark venues are able to attract trades from lit venues because regulations, specifically tick sizes, encourage traders under certain circumstances to shift trades into the dark, affecting liquidity on lit exchanges.

This has led to a call for reforms, ranging from tick size changes to a Trade At Rule. Others believe that markets benefit from a multiplicity of venues.

Amy Kwan, author of the report, explained her findings: "Our focus is on a particular trading rule, which is this minimum pricing increment."

That's because on US exchanges, the minimum pricing increment is a cent. If there is additional trading interest there are going to be long queues at the best bid and ask prices unless someone crosses to trade.

"With these long queues, what some traders can do is to bypass these queues and trade immediately in the dark pool. So we are saying when the minimum pricing increment is a constraint on trading in the lit exchanges, people will bypass these queues by trading in dark pools," she said.

That means a lot of volume going to dark pools, which leads to increasing growth and market share.

Kwan said the result is that dark pools would have a competitive advantage when the price is above a dollar, an advantage they lose when the price goes below a dollar, at which point their market share drops correspondingly.


Kwan added that traders using dark pools in this way took liquidity away from lit exchanges, and the phenomenon was also seen when higher priced stocks traded.

Andrew Upward, a market structure analyst with Rosenblatt Securities, said that in the US markets this phenomenon did happen but he did not believe "that it happens in the same way as some critics of the way that exchanges operate might describe a violation of price-time priority"...

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