Dark trading in Australia
What is dark trading?
Dark trading is trading that occurs without pre-trade transparency. Although dark trading has always been a feature of equity markets, in recent years markets around the world have exhibited substantial growth in the level of dark trading and a change in the manner in which dark trading takes place. New trading venues, known as dark pools, have emerged. These venues systematically match orders without providing any pre-trade transparency and without providing access to this liquidity to the market at large. Dark pools are also typically subject to less regulatory scrutiny than traditional stock exchanges.
Advocates of dark trading argue that it allows them to reduce trading costs and reduce information leakage associated with large trades. However, many regulators have expressed concern that the migration of trading volume to the dark may reduce liquidity and harm price discovery – two fundamentally important characteristics of equity markets.1
If dark trading does in fact harm liquidity and price discovery, then new regulatory policy needs to be developed to constrain the growth in dark trading.
There has been a significant increase in the level of dark trading in many markets around the world. As a result, the issue has received attention from global securities market regulators. The growth in dark trading has been most extreme in the US, where the level of dark trading has increased from approximately 16% of total volume in January 2008 to a record high of almost 37% in January 2013 (Rosenblatt Securities).
Dark trading in Australia
In a recent research paper 2, we examined the impact of dark trading in the Australian market. We examine the Australian market due to the highly granular level of data available on dark trading in this market. However, the findings are also applicable to other markets.
In Australia, the level of dark trading has not accelerated at the same rate as it has in the US. Over the period February 2008 to October 2011, dark trading fluctuated between 14% and 22% of the dollar value traded, without showing any obvious trend. There has however been a significant change in the nature of dark trading and the mechanisms used to execute dark trades. During this period most large brokerage firms have established dark pools which allow them to systematically match orders away from the licensed exchanges. There has been a significant decrease in the average trade size and a significant increase in the number of trades executed in the dark. There has also been a shift in dark trading away from blocks toward trades below block size.
Dark trading and price discovery
Our paper examines the impact of dark trading in Australia on a critical aspect of market quality – price discovery. Specifically, we analyze the impact of the migration of order flow to the dark on the informational efficiency of prices. We also investigate how the process of price discovery changes in response to order flow migration to the dark. We separately consider dark block trades and dark trades below block size.
For dark trades below block size, our results show that informational efficiency is negatively related to the share of volume and trades executed in the dark, suggesting dark trading below block size harms aggregate price discovery. Our results also show that as order flow migrates from lit to dark trading mechanisms the contribution of trade prices to price discovery declines relative to quotes displayed in the lit exchange. One reason why dark trading below block size harms price discovery is that the loss of pre-trade information on the order flow that leaves the lit exchange leads to less efficient aggregation of the information contained in order flow. Furthermore, our results indicate that higher levels of dark trading below block size are associated with wider spreads and larger price impacts in the lit exchange, both of which act as a disincentive to analyzing and trading on information. Our results are robust to a number of control variables, hold in both large and small stocks and early and later parts of our sample period. Our preliminary evidence suggests that the share of volume executed in the dark below block size has a nonlinear effect on price discovery. At low levels, i.e., less than 10% of volume dark trading below block size has an insignificant effect on price discovery, however as it increases above 10% of dollar volume informational efficiency deteriorates. For example, an increase in dark trading below block size from 10% to 20% of dollar volume is estimated to increase the informational inefficiency measures by 10% to 15% of a standard deviation. This suggests that the relation between dark trading below block size and aggregate price discovery is not only statistically significant but also economically meaningful.
Our results also indicate that not all dark trading has the same effects on price discovery. 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. Therefore, regulation to constrain dark trading needs to be carefully designed to limit the migration of order flow that is beneficial to the lit market, while allowing order flow that does not contribute much to price discovery (or may even detract from price discovery) to occur in the dark. Our research on how to best make this distinction is ongoing and we hope to be able to offer insights on this issue in due course.
 For example, the International Organization of Securities Commissions (IIROC) in a 2011 report by the Technical Committee states that “the development of dark pools and use of dark orders could inhibit price discovery if orders that otherwise might have been publicly displayed become dark”. The European Commission in a 2010 consultation paper raises the concern that “increased use of dark pools … may ultimately affect the quality of the price discovery process on the ‘lit’ markets”. The Australian Securities and Investment Commission in a 2011 consultation paper state that “pre-trade transparency is fundamental to price formation”.
 A complete copy of the paper is available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2183392
About Carole Comerton-Forde
Carole Comerton-Forde is Professor of Finance at the University of Melbourne. Her research is in the area of market structure, with a focus on market liquidity and market integrity. Her current interests include the impact of high frequency trading and dark pools on market quality. Her research has been published in leading academic journals including the Journal of Finance and the Journal of Financial and Quantitative Analysis. Carole has previously held academic positions at the Australian National University, University of Sydney, New York University and was a Visiting Economist at the New York Stock Exchange. She has also acted as a consultant for a number of stock exchanges and market regulators around the world. She is currently acting as an economic consultant on market structure issues with the Australian Securities and Investments Commission.
About Tālis Putniņš
Talis Putnins is the Chancellor's Postdoctoral Research Fellow in Finance at the UTS Business School in Sydney, and Research Associate at the Stockholm School of Economics in Riga. His main research interests include financial market microstructure, liquidity, price discovery, and market manipulation. His research has been published in peer-reviewed journals such as Journal of Financial and Quantitative Analysis, Journal of Financial Intermediation, and the Review of Finance. Talis has worked as a consultant for the Latvian government, Nasdaq OMX, a number of banks, and has acted as an expert witness in legal cases involving financial securities. He has a PhD from the University of Sydney.