NO 243 – MAY 2013

WFE Focus May 2013

Executive Summary

The World Federation of Exchanges (WFE) commends IOSCO for carefully analyzing the issues raised by the growing and disruptive fragmentation and loss of visibility (darkness) in equity markets. The four sensible recommendations in this consultation progress efforts on the part of regulators and exchange operators worldwide to ensure that equity markets continue to serve investors by becoming ever more efficient, transparent and fair.

The WFE supports competition and believes that regulators must promote market designs that foster order interaction in a free, transparent and fair competitive environment. Unfortunately, regulations intended to promote competition between and on-exchanges have in recent years been misused to enable the growth of venues designed to avoid competition.

The WFE is concerned about the integrity and efficiency of fragmented, complex and dark markets, particularly as it relates to price formation, surveillance, and market resiliency. Market participants are increasingly discouraged from posting competing prices in lit venues, and evidence indicates that spreads are wider than they could be otherwise. Similarly, diminishing transparency and fair access leads to market complexity that makes markets less capable of handling volatility. Finally, the WFE is concerned that a greater share of equities trading occurs away from full regulatory protection offered by regulated exchanges.

The WFE calls into question two common practices in fragmented markets. First, retail and institutional orders are systematically segmented toward venues designed to avoid quote competition, where conflicts of interest are unavoidable. Second, fragmented markets increasingly allow participants to step in front of displayed public limit orders on dark venues with little to no price improvement or block trading. The incentive to segment markets and reduce transparency jeopardizes the price discovery process and can adversely impact costs for all investors. .

The WFE calls attention to the problems that investors and security commissions face in receiving reliable data from over-the-counter (OTC) equity trading venues. While the WFE believes that the quality of data, and the costs associated with aggregating data should be weighed when changes to market structure are considered, consistent transparency regulations across venues is fundamental to efficient trading and market surveillance.

The WFE supports recent changes made by the security commissions of Canada and Australia in curbing the excesses of OTC equity trading.

Monitoring the impact of fragmentation on market integrity and efficiency

Recommendation 1

1.1 Regulators should regularly monitor the impact of fragmentation on equities market integrity and efficiency across different trading spaces and seek to ensure that the applicable regulatory requirements are still appropriate to protect investors and ensure market integrity and efficiency, including with regard to price formation, bearing in mind the different functions that each trading space performs.

1.2 Regulators should regularly evaluate the regulatory requirements imposed on different equities trading spaces and seek to ensure that they are consistent (but not necessarily identical) across spaces that offer similar services for similar instruments.


1. Does the evolving market fragmentation challenge the relevance, effectiveness or implementation of current regulatory requirements? If so, which ones and how are they impacted?

2. Are you aware of material differences in regulatory requirements between different trading spaces that from your point of view are not justified and create regulatory risks and unfair competition? For example, are there regulatory requirements that apply to one type of trading space in your jurisdiction and currently do not apply to others but, in your view, should apply to others that offer similar services? Please describe.

3. Do you think that the price formation process has been deteriorated or has been improved as the result of market fragmentation? If so, please explain how.

WFE Response:

As more trading volume migrates from public, more regulated “lit” exchanges to private, less regulated, dark venues, there is growing evidence of declining market quality that raises investor costs and undermines public confidence and participation in capital markets. This is illustrated by the frequency of media attention to once obscure market structure topics such as dark pools, high frequency trading, and order types. These practices attract the fearful attention of the public - inevitable responses to a highly fragmented, complex and obfuscated market.

This concern is shared by the buy-side as explained in Kevin Cronin’s (Global Head of Equity Trading, Invesco, on behalf of the Investment Company Institute) testimony to the US House of Representatives: “We recognize that while the use of un-displayed liquidity brings certain benefits to funds, there are concerns about its impact on the price discovery process. Ideally, funds would like as many orders as possible to be executed in the lit markets. ICI therefore has strongly supported efforts to provide incentives for market participants to use transparent orders. Until we create a more efficient market structure for the execution of institutional sized orders, however, it is imperative that venues providing un-displayed liquidity remain available to funds and that the regulations overseeing these venues facilitate their continued use.”

Inconsistent Rules Lead to Fractured Markets

In Europe, MiFID included different regulatory requirements for “Regulated Markets” (RMs) and “Multilateral Trading Facilities” (MTFs) on the one hand and “Broker Dealer Crossing Networks” (BDCNs) on the other. BDCNs are exchange-like trading platforms operated by investment banks offering trading in equities. They provide similar services as RMs and MTFs but are not subject to regulatory requirements for trading venues. Hence, activity on BDCNs falls into the category of over-the-counter (OTC) trading. Those differences in regulatory approach are not justified and create regulatory risk as the matching of orders is conducted away from transparent markets and is exempt from a competitive price determination process. There is no guarantee that the orders are fairly priced. Additionally the whole market is diminished because a growing proportion of order flow is excluded from the price formation process.

Furthermore, those differences create unfair competition as BDCNs offer their services with discriminatory access, meaning the owner determines who can access their platform. And because trading occurs at the discretion of the owner conflicts of interest are unchecked.

As noted in the study MiFID, Spirit and Reality of a European Financial Markets Directive: “The development of Broker Dealer Crossing Networks (BDCNs) creates second class investors. While MiFID has imposed non-discretionary access rules to the various regulated venues, BDCNs are allowed to provide access to selected customers across the various market participant types (traditional buy side, other sell side, hedge funds, etc.). Therefore, access to this liquidity pool is not set on a fair basis, and some market participants that cannot afford, or do not wish, to become customers of the BCNs are very likely to become second class investors unable to access the whole liquidity pool available in the market. This situation is even more acute today since numerous BCNs are becoming linked to one another to create a cloud of crossing networks that will deepen their pool of liquidity and increase the likelihood of execution.”1

In the US, the regulatory landscape facilitates and encourages off-exchange trading by allowing OTC venues to utilize different practices than exchanges, including the following:

Customer segmentation;

  • Ability to trade at the NBBO without quoting;
  • Ability to offer de-minimis, sub-penny price improvement;
  • No pre-trade, and limited post-trade, transparency;
  • Ability to send “Indications of Interest” (IOIs) to a select network of customers rather than publishing them as quotes to the public;
  • Lack of affirmative regulatory obligations including the rulemaking process and publicly-disclosed rules;
  • Less regulatory oversight of participants and cost;
  • Reduced transparency and higher profitability further incentivizes liquidity.

According to a report by TABB Group, the discretionary latitude given to dark pools results in “little transparency into order placement logic, linkages, wait-times, routing priorities and how best execution is measured at a particular point in time.”

In addition they note that the majority of buy-side traders “do not have the resources to actively monitor dark activity or scrutinize every trade when trading using broker algorithms, and rely on broker best-ex obligations, their own trading experience and transaction cost analysis reports.“

The lack of transparency is at times detrimental to investors as illustrated by recent cases in the US where confidential information is not protected2 or trading by an affiliate is not disclosed3.

The TABB Group report continues: “The quality of execution data is, however, skewed by the fact that the earliest and easiest executions occur off-exchange, the least visible part of the market. By the time executions occur on the lit market, information has leaked. The proprietary nature of dark platforms requires a level of protection to safeguard innovation and competitive edge. Yet internalization raises questions of fairness, if trading interest can be observed without commitment to trade, and indications of interest create an exclusive network of activity.”

Nominal price improvement is based on a benchmark that has itself been negatively affected by segmenting retail order flow. As Larry Harris notes: “dealers only pay for order flow that they believe comes largely from uninformed trades” (i.e. retail investors orders, which are part of the utilitarian traders as opposed to informed traders and dealers). But “the diversion of order flow from exchanges decreases market quality at the exchanges by removing utilitarian order flow”. This issue clearly relates to price formation as “markets that have many utilitarian traders tend to be liquid markets with informationally efficient prices”.4

A recent study particularly has demonstrated that “higher levels of dark trading are associated with decreased price discovery and less informationally efficient prices”5. The authors also note that: “order flow that migrates to the dark is less informed than that which is left behind, but it is not entirely uninformed. Therefore loss of  pre-trade information on migrating order flow harms price discovery. It also increases adverse selection risk, bid-ask spreads and price impact in the transparent exchange”. This report also concluded that the negative aspects OTC equity trading occur at much lower levels of fragmentation – as little as 10% of trading away from lit markets harms market quality. The Australian Securities and Investments Commission (ASIC) published its findings in March 2013 confirming the impact on spreads from OTC equity trading.6

Off-exchange equity trading has grown well beyond its intended purpose. Dark pools and other alternative trading venues were originally intended to allow institutional investors to trade large blocks of stock without negatively impacting the price of the security. From this useful, but narrow role, this growing practice has morphed to the point where a majority of trading several thousand US equities now takes place “in the dark” away from public exchanges.

Fragmentation occurs when liquidity is not centralized but dispersed across numerous trading venues. If the information of the order flow fractions cannot interact, the price determination process would be severely harmed. In order to avoid this negative effect of fragmentation, a high level of transparency is necessary. This can be achieved if the whole market applies the greatest level of pre- and post-trade transparency. However, information about prices is in the public interest, which market participants want to benefit from but have no incentive to contribute to as they intend to hide their own information advantage. Hence, market participants want to benefit from the price determination of the market but do not want to share their own information.7 This is a dilemma which makes trading away from transparent markets appealing.

However, MiFID deregulated price competition in European markets in 2007. A transparency regime was introduced in order to overcome negative effects of fragmentation such as the deterioration of the price formation process. In addition, waivers of pre-trade transparency were introduced in order to grant execution variety. Those waivers are the “large in scale waiver”, the “negotiated trade waiver”, the “order management facility waiver” and the “reference price waiver”. The latter waiver is of special interest in this context, as its original purpose is to enable trading of big tickets without detrimental market impact. On top of that, MiFID explicitly excluded the OTC equity trading space from its scope.

Therefore, in the contemporary European market, trading is fragmented between numerous venues, such as MiFID regulated lit and dark markets (as operated by RMs and MTFs) and the unregulated OTC equity space. Lit RMs and MTFs apply the transparency rules and dark RMs and MTFs apply the aforementioned waivers. Hence, a certain portion of order flow is exempt from the price formation of the lit market. Currently, the market share of European dark markets, which use the reference price waiver, is below 10 percent but if Europe follows the global trend those venues will grow and price formation will be severely harmed due to the fact that a big portion of information is exempt from the price determination on the lit market. The US market where nearly 40% of trading is “in the dark” might serve as an example of how OTC equity trading can gain critical mass. Dark trading is very appealing as market participants seek to insulate their trading from public market competition.

Finally, it is difficult to measure the deterioration of the price formation process. However, the exemptions of order flow volumes from dark trading and the OTC space decrease the amount of information which forms part of the price determination of the market. As transparency is the best way to avoid the negative effects of fragmentation the aim should be for the largest possible amount of information to form part of the price determination process.

Regulators are Beginning to Take Action

Regulators around the world are taking the lead in improving market quality and confidence by effectively addressing off-exchange trading by making sensible changes. In particular, Canada and Australia implemented regulatory changes that require off-exchange venues to offer a minimum level of price improvement before a trade can be executed. Requiring OTC equity trading to provide a material and measurable benefit to their participants represents an appropriate regulatory recognition of the benefits to investors and listed companies of price transparency and competition.

As noted in the 2001 IOSCO Report: “if competition is working well, one would expect the benefits to be manifesting themselves not solely in market share increases for successful service providers but also in such indicators as rising market volumes and narrowing spreads”8.

The opposite is happening as trading volumes have declined and a growing body of research shows that market fragmentation onto dark markets has led to deterioration in the price formation process:

  • Internalization and Market Quality in a Fragmented Market Structure – Weaver (2011)
  • Dark Pools, Internalization, and Equity Market Quality – CFA Institute (2012)
  • The Impact of Dark Trading and Visible Fragmentation on Market Quality – Degryse, de Jong, and van Kervel (2011)
  • Dark Trading and Price Discovery – Comerton-Forde and Putnins (2012)

Monitoring the impact of fragmentation on trade information

Recommendation 2

In an environment where equities trading is fragmented across multiple trading spaces, regulators should seek to ensure that proper arrangements are in place in order to facilitate the consolidation and dissemination of information as close to real time as it is technically possible and reasonable.


1. What options are available to manage the issues associated with data fragmentation in a competitive environment?

2. What conditions, if any, should govern access by investors to consolidated market data?

3. Are there other challenges (technical, regulatory, prohibitively high costs) with regard to creating and/or accessing consolidated market data? What if anything, should be done to address these challenges?

4. What views do you have on the relative merits of a single consolidated tape mandated by the regulation versus multiple competing tape providers? Please elaborate.

WFE response:

One of the most serious and expensive challenges of disorderly fragmentation is the necessity to consolidate data to assure reliable market surveillance and execution quality measurement. The Consolidated Audit Trail in the U.S illustrates how regulators and market participants must spend huge sums of money to overcome fragmentation to enable effective surveillance. This cost is ultimately borne by investors, calling into question whether the claimed benefits of unrestricted fragmentation could exceed the direct cost of regulation.

There is no one size fits all solution for effective market data distribution and consolidation. But it is fundamental that investors have equal access to visibility into the venues where price formation is happening. Assuring the widest possible access to data often requires offering different price levels that depend on a customer type and the intensity of their usage, but principles of fair access must prevail.

Data consolidation can be done in a variety of ways as long as the data is publicly available and uses consistent standards. Even before the introduction of MiFID I the German market had been fragmented and data was consolidated without problems (and no Central Tapes). With the introduction of MiFID, OTC equity data had to be published as well. However, any consolidated views on a combined data set of trading venues data with OTC data in the EU has failed to come up with usable solution. The reason behind this is that OTC market data tends to be a) unreliable in terms of published overall volume and b) subject to significant time delays compared to trading venues data. The mix of data of different quality therefore impacts the potential value of a consolidated view.

In order to improve the quality of OTC data and in order to facilitate easy consolidation a set of necessary pre-requisites (e.g. standards, harmonized trade reporting requirements, compliance enforcements) needs to be established and introduced to enable any sort of consolidation, be it via a centralized plan (U.S. style) or be it decentralized, within the spirit of MiFID.

Within Europe the introduction of Approved Publication Arrangements will certainly improve the quality of OTC data. Clear reporting publication rules, however, especially in case of trades across national jurisdiction, will need to be implemented as well, in order to improve the reliability of OTC trade reporting going forward.

Furthermore, any significant deviation to real-time publication (e.g. publication delays allowed by MiFID) will in fact reduce the usefulness of a real-time consolidated tape. Therefore, any publication delays should be reduced to a minimum.

Monitoring the impact of fragmentation on order handling rules and best execution

Recommendation 3

Where equity markets are fragmented, regulators should consider the potential impact of fragmentation on the ability of intermediaries to comply with applicable order handling rules including, where relevant, best execution obligations, and take the necessary steps.


1. Should existing order handling rules, such as best execution, be re-examined in the context of fragmented markets? If so, in what way?

2. Do you think that rules relating to the disclosure of order handling practices by investment firms are appropriate to facilitate compliance with and evaluation of ‘best execution’?

3. Are there any other appropriate ‘order handling’ tools that should be considered in the context of fragmented markets?

WFE response:

The fundamental problem in evaluating order handling and execution quality is finding an appropriate benchmark. The competitively determined best bid and offer is a crucial benchmark for all investors but its quality depends on aggressive and visible quote competition. Fragmentation in recent years has been dominated by venues designed to reduce quote competition, leaving a diminishing amount of activity competing in transparent markets. Diminishing competition can only lead to one outcome: a lower quality benchmark than what would otherwise be possible.

In some regions the problem is compounded because there is not effective post-trade transparency for OTC equity trades. OTC equity data is not standardized, which in turn reduces the information content of OTC-reported prices significantly. This makes a direct comparison or traceability of best execution results difficult. Better OTC data quality is necessary, as this will enable clients to compare the best execution efforts of their banks/brokers.

In addition to the decline in the national best bid and offer (NBBO) and last sale benchmarks, off exchange trading can have a direct and difficult to measure impact on execution quality. As discussed by Professor Larry Harris, in the case of internalization (and fragmentation more generally) “the immediate incentives to obtain best execution for their orders are small”. Elaborating on this idea, Professor Harris notes that “in principle, these problems would not arise if clients could easily determine whether  their brokers were obtaining best execution for their orders.” But, “in practice, brokerage clients, and especially retail clients—cannot easily determine whether the prices that their brokers obtain for their orders are as good as they could have obtained. To do so, they must know what market conditions prevailed when they submitted their orders, and they must compare their execution prices to the prices that they would have expected to receive, given those market conditions.

This process is very data intensive, and reliable results require analytic modeling skills that are substantially beyond the expertise of most clients. At best, retail clients only have a weak sense of whether their executions occur at favorable prices, and then only to the extent that their execution prices are at or within the bid/ask prices that their brokers may or may not present to them, and even then, only if the clients are paying attention. In contrast, institutional clients generally employ consultants to analyze the executions of their orders.”9

Conflicts of interest are therefore apparent in motivation for intermediaries to trade on OTC equity venues. The next question is the extent to which this is common. A recent CFA Institute study highlights the fact that almost 100% of retail market orders are internalized10. This segmentation of order flow raises fundamental question as noted in IOSCO Transparency and Market Fragmentation report (2001)11.

It would appear to be a difficult task to create rules that would reassure investors that their trades are being properly executed in the current environment. A rule for ‘meaningful’ price improvement would simplify the task. Another improvement would be to place more disclosure between intermediaries and their clients on the decision process that the broker uses for executing trades, and make client consent more explicit. If more information were obligatory, the competition between intermediaries to be seen as providing a better service may be a useful tool in restoring market integrity.

Monitoring the impact of fragmentation on access to liquidity

Recommendation 4

Regulators should regularly monitor the impact of fragmentation on liquidity across trading spaces.

Regulators should seek to ensure that applicable regulatory requirements provide for fair and reasonable access to significant sources of market liquidity on the exchange and non-exchange trading market systems.


1. Do you have views on regulatory mechanisms and specific arrangements that might be needed to help ensure that investors have an appropriate, fair and reasonable access to liquidity in both exchange and non-exchange trading market systems? If yes, please elaborate.

2. Are there any other issues resulting from the market fragmentation that should be addressed with respect to access to liquidity on exchange and non-exchange trading market systems?

WFE response:

In its 2001 report, the IOSCO Technical Committee noted that the principal source of competition between trading venues was either order-matching systems competing with traditional quote-driven/dealer markets or trading systems designed to remove market impact for block orders.

Today, looking at OTC equity trading venues operating () in most jurisdictions, very few are actually transacting block orders, instead presenting similar features to traditional quote-driven/dealer markets (lack of transparency, discretionary rules). This outcome does not fit with the initial purpose of introducing more competition among trading venues.

The OTC markets have been able to replicate with new technology some of the characteristics that once marked floor trading at stock exchanges. Some of these features of how orders are handled were banned on exchanges years ago, in some cases because of intrinsic conflicts of interest, so that price/time priority became the standard for fairness on central limit order books.

As noted in the study MiFID, Spirit and Reality of a European Financial Markets Directive: “Reliance on OTC equity market operations should be closely supervised. The current level of equity transactions that are conducted OTC pose a real threat to the order-driven model of the European cash equity market. The situation is even more acute with the development of BDCNs that could capture more market share from the regulated trading venues (regulated markets, MTFs, and systematic internalizers (SI). With negotiation happening in the OTC space, the price discovery mechanism happening on the “lit” market could be severely impacted, pushing the equity market to become a quote-driven market very similar to the structure in place in commoditized OTC asset classes that are the fixed income and spot FX markets.”

In the contemporary fragmented European equity market, it is of major importance to ensure that market participants have equal access to overall liquidity. Equal access is not required for the non-exchange trading market systems such as BCNs. In order to cover for the BCN issue, MiFID II envisages the Other Trading Facility (OTF) category. Currently, it is not intended to require equal access to those trading systems. In order to ensure a well-functioning European market it should be guaranteed that all market participants are treated equally and in a non-discriminatory manner, which in turn ensures equal trading opportunities to the overall market. Therefore, the OTF category should be required to offer non-discriminatory access.

However in the cash equity markets, regulatory incentives are still skewed in the opposite direction in several major jurisdictions, allowing powerful economic incentives to drive trading towards OTC equity markets.

The minimal initial first step would be to disclose accurate and reliable volumes transacted on all trading venues competing to attract orders. As already highlighted, the mere existence of non-transparent venues applying discretionary rules raises significant issues regarding the extent to which their supposed liquidity can be accessed. As quoted above, TABB Group raised serious concerns in reference to internalization “if trading interest can be observed without commitment to trade, and indications of interest create an exclusive network of activity”.

Several studies have raised the point that OTC equity trading has a detrimental effect on liquidity measures resulting in higher spreads and lower depth. Degryse, de Jong, and van Kervel (2013) posit that the negative impact of dark trading is consistent with a “cream-skimming” effect between dark and visible markets.12

In the European fragmented market it should be ensured that the same access requirements apply to exchange and exchange-like trading systems such as MTF’s. MiFID stipulates a set of criteria for the regulated markets’ admission of members. MTF’s have the ability to choose the clients they accept. Regulated markets and MTF’s should be ruled similarly in this regard, and discriminatory access should be abolished.

Monitoring the impact of fragmentation on market efficiency and resilience

Recommendations from October 2011 IOSCO report on Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency:

Recommendation 4: “Regulators should continue to assess the impact on market integrity and efficiency of technological developments and market structure changes, including algorithmic and high frequency trading. Based on this, regulators should seek to ensure that suitable measures are taken to mitigate any related risks to market integrity and efficiency, including any risks to price formation or to the resiliency and stability of markets, to which such developments give rise” and,

Recommendation 5: “Market authorities should monitor for novel forms or variations of market abuse that may arise as a result of technological developments and take action as necessary. They should also review their arrangements (including cross-border information sharing arrangements) and capabilities for the continuous monitoring of trading (including transactions, orders entered or orders cancelled) to help ensure that they remain effective.”


1. Are there any regulatory requirements that should be examined in addition to the recommendations already made in the above mentioned IOSCO reports in light of the evolution of market structure and trading strategies in the very specific context of market fragmentation? If so, please describe.

2. Are there any other issues associated with the fragmentation of markets that have not been mentioned in the current report?

3. Are there any changes to regulatory structure that you would recommend to regulators in your jurisdiction to address issues raised by market fragmentation? If yes, please elaborate.

WFE response:

As noted by Andrew G. Haldane13, past a certain point, the more complex a system is the less stable it is. The 2010 flash crash and other examples illustrate the difficulties presented by equity market complexity in some jurisdictions. As noted by TABB Group: “the inability to determine what is happening in the marketplace results from an increasingly complex ecosystem, including greater dark trading and fragmentation.”

The current level of equity market fragmentation in certain jurisdiction has led to an unprecedentedly complex market structure which has eroded public confidence in markets. The various examples noted above demonstrate this fact and as summed up by TABB Group “market structure confidence in the US is low, one-third of US equity trading is executed on a non-exchange venue, and the makeup of this volume lacks transparency”.

The negative impact of fragmentation on primary markets is all the more serious because of the deterioration of market quality for the market overall. As the quality of secondary markets declines, especially as many stocks suffer from lack of visible liquidity and the overall market confidence is negatively impacted by fragmentation, it increases the cost of capital and affects negatively primary markets (listing and raising capital for companies).

MiFID, Spirit and Reality of a European Financial Markets Directive p 62 -63
SEC Charges Boston-Based Dark Pool Operator for Failing to Protect Confidential Information, SEC press release (2012)
Alternative Trading System Agrees to Settle Charges That It Failed to Disclose Trading by an Affiliate, SEC press release (2012)
Regulated Exchanges: Dynamic Agents of Economic Growth (2010)
Dark Trading and Price Discovery, Comerton-Forde and Putnins (2012)
Dark Liquidity and high-frequency trading, ASIC, pg 32-38
European Securities Markets Expert Group, “Fact finding regarding the developments of certain aspects of pretrade transparency in equities under MiFID”, report 27/07/2009
Larry Harris, op. cit., our emphasis
Dark Pools, Internalization, and Equity Market Quality, CFA Institute (2012), p. 17
Celent Pages 9-10, 22.
The impact of dark and visible fragmentation on market quality (2013)
Rethinking the Financial Network (2009)