NO 240 – FEBRUARY 2013
Happy year of snake

WFE Focus February 2013
Dark Liquidity
Peter Clifford
Chief Operating Officer,

The first WFE events in the Year of Snake appropriately took place in the Asia / Pacific region with visits to exchanges interested in joining the Federation, as well as a meeting open to all members as the Working Committee reviewed priorities for 2013.

For Focus readers, one souvenir from down under is the executive summary on page three of research recently completed by Carole Comerton-Forde of the University of Melbourne and Talis Putnins from the UTS Business School. Their work on ‘dark liquidity’ is being examined by followers of market structure and regulation debates around the world.

For investors and regulators following the growing trend to dark liquidity, the list of concerns have always included the risks associated with reduced transparency, increased fragmentation, greater complexity, more difficult regulation, higher spreads, higher volatility, damage to price discovery, and higher overall costs to the market.

Regulators have been concerned about the overall level dark trading for the entire market, but research on markets where dark trading is at an early stage had not been able to suggest a threshold at which the savings from executing a trade out of sight of other investors was offset by increased costs to the entire market, both lit and dark, from weaker price formation. Some had supposed that 30 or 40% of trading in dark venues might be the tipping point where a negative impact could be felt based on markets which were already very dark. However, the Australian study indicated that the level may be much lower (10%).

The overall percentage of dark trading in a market is a key figure for investors to watch. At a more granular level, investors are equally concerned about the types of orders that are being diverted from lit markets. The CFA Institute study on US equity markets highlighted the fact that nearly 100% of market orders, mostly from retail traders, are routinely diverted to dark execution venues. This practice, known as segmenting order flow or internalizing trades, deprives lit markets of the major component for liquidity and may result in retail investors get less price improvement than if the orders has been exposed to the market. A second finding of the Australian research observes that while dark liquidity venues were created for block orders, most of the trading in dark pools is of a size similar to trades on lit markets. As stated by the authors: “Block trading does not harm price discovery; if anything it is beneficial to the market to have large block trades negotiated away from the lit central limit order book.” But they also found: “For dark trades below block size our results show that informational efficiency is negatively related to the share of volumes and trades executed in the dark suggesting dark trading below block size harms aggregate price discovery.”

In Canada, new regulation restricting dark trading seems to be having a positive impact on market quality. The requirement that brokers must propose “meaningful” price improvement for small orders before resorting to dark liquidity venues has only recently been implemented. However, the first indications suggest that it will have a positive impact as it does not appear to interfere with mid-point matches or block trades, but does seem to cut down on questionable practices of shaving the spread to jump the cue.

The meetings in Sydney were also the occasion to catch up with developments in the emerging markets, and here from some of our new members. A quick overview of the Abu Dhabi Securities Exchange is provided on page 5 by the CEO Rashed Al Baloushi. The Director General Of the Muscat Securities Market, Ahmed Saleh Al-Marhoon also update the reader on the market developments in Oman.