From the Regulators

Nevertheless, the report finds that HFTs reduced their provision of liquidity in dark trading venues significantly after the rule change

By James Langton |

The introduction of price improvement requirements in dark markets introduced in Canada in 2012 have had no impact on markets, overall, although it did lead to shift from dark trading to lit markets, which may have raised retail traders' costs, suggests a new paper from the Investment Industry Regulatory Organization of Canada (IIROC) published on Friday.

IIROC commissioned a trio of academics — Andreas Park and Katya Malinova from the University of Toronto and Carole Comerton-Forde from the University of Melbourne in Australia — to examine the impact of new dark trading rules introduced in October 2012. In the paper, which is entitled The Impact of the Dark Trading Rules and published without editorial comment from IIROC, the academics say, "We find no evidence that the change in regulations affected market-wide price efficiency, volatility or trading costs [measured by bid-ask spreads]."

Although the volume of securities traded in the dark did drop significantly after the imposition of the rules, the paper notes that the entire decline came in one of the two major dark venues, while the other was largely untouched by the rules: "We believe that the decline in dark trading volume was driven by a reduction in liquidity supply and we attribute the differential impact of the price improvement rule on the two dark markets to pre-event differences in the nature of liquidity provision."

Park, Malinova, and Comerton-Forde also examined the effects of the rules on several trader groups: retail investors, high-frequency traders (HFTs), buy-side institutions and "other" players.

The report states that "intraday returns for retail traders declined weakly after the change in regulations, and that the decline is more pronounced if we account for trading venues' maker-taker fees. [As] most brokers do not pass exchange-trading fees to retail customers on a trade-by-trade basis [but charge flat commissions instead], the change in regulations may have led to an increase in costs for retail brokers."

After the rule change, HFTs reduced their provision of liquidity in dark trading venues significantly, the report says, whereas buy-side traders increased their supply of liquidity in these venues. The paper notes that the fill rates for passive orders that HFTs submitted increased in several lit markets — and the fill rates for buy-side institutions declined. At the same time, buy-side traders' fill rates for orders that are sent to dark markets increased.

"The introduction of the price improvement rule made it impossible to ‘earn the spread' by trading on both sides in a dark market, thus reducing the incentives to make the market there," the IIROC report notes. "As a consequence, traders who posted two-sided orders to the dark pools prior to the change reduced their participation on these venues significantly."

The share of retail investors' marketable orders that execute in the dark declined and the share executing in lit markets increases, the IIROC report states: "The change in dark liquidity rules was associated with a redistribution of marketable retail order flow, which appears to have increased exchange fees incurred by retail brokers."

The IIROC paper also concludes that "the segmentation of order flow affects market quality, and in particular the segregation of retail order flow may harm lit market liquidity."

This paper is the first of two that are forthcoming from this team of academics, which is one of four teams that are examining the impact of HFT on Canadian equity market, as part of IIROC's efforts to study various aspects of HFT and market structure. Their other paper is due by the summer.

IIROC says it will review and discuss all of the papers it has commissioned internally, with other regulators and key stakeholders before determining what, if any, regulatory response may be required in light of the findings.