A recent 86 page report by the CFA Institute titled “Dark Pools, Internalization, and Equity Market Quality” has been receiving a lot of attention. The report takes a critical view of dark pools. It states: “When a majority of trading occurs in undisplayed venues, the benefits of competition are eroded and market quality will likely deteriorate.”
The report has three main recommendations: “To protect market integrity, we recommend that (1) internalization of retail orders be required to offer meaningful price improvement, (2) regulators monitor the growth in dark trading and take appropriate measures if it grows excessively, and (3) dark trading facilities improve reporting and disclosures around their operations to enable investors and regulators to make more informed decisions about their use.”
It is clear that the authors feel the rapid rise of undisplayed liquidity is hurting market integrity and the price discovery process. While we think there is a place for institutional sized crossing networks that seek to match natural buyers and sellers, we agree with the authors that the excessive number of dark destinations have distorted pricing in the equity market. The authors do take particular exception with the practice of internalization which is when “broker/dealers internally executing client order flow against their own accounts on a systematic basis…these market makers may discriminate among the counterparties that they will accept orders from.” These internalizers essentially have a free option to trade with uninformed retail orders. And as we all witnessed in the May 2010 flash crash, most of these internalizers shut down when the market got volatile and the retail order flow was shipped directly to the lit exchanges.
The paper does a good job of summarizing Reg NMS and Reg ATS as well as reviewing some academic literature on dark trading. They also do an excellent analysis of a sample group of data from 2009 to 2011. The conclusion from their data analysis is: “Findings suggest that a higher incidence of dark trading is associated with improvements in market quality, although the improvements are not indefinite. Taking all these findings together, a conservative assessment would be that when the majority of trading in a stock (>50%) occurs in undisplayed venues, market quality will likely deteriorate.”
Overall, we agree with the recommendations of the authors. And we would like to point out that the SEC also probably would agree with a majority of this report. We can say this because in October 2009, the SEC published a proposal titled “Regulation of Non-Public Trading Interest” where they tackled many of the same issues the CFA report tackles. Unfortunately, the SEC proposal still sits in their files since it was never approved.
Another group likely to agree with the reports findings are the stock exchanges. They have been losing flow to dark pools at an alarming rate and will likely tout this report as evidence that too much dark volume is dangerous. The exchange argument, however, would be much stronger if they weren’t such hypocrites. Instead of standing firm and trying to fight the internalizers and dark pools, the exchanges have all recently embraced them by creating their own dark retail liquidity programs. If the exchanges really want us to take them seriously, they would voluntarily remove their dark retail liquidity programs from the market.