The U.S. trading rules may be inadvertently favouring dark pools over lit markets suggests new research from Australia’s Capital Markets Cooperative Research Centre (CMCRC).
In a new paper that will soon be published in the Journal of Financial Economics, the CMCRC says that its research found that trading rules in the U.S. “may be providing dark venues a regulatory advantage over traditional stock exchanges by allowing some traders to circumvent time priority, leading to the rapid growth of dark trading in U.S. equity markets.”
It notes that market share for dark pools has increased notably over the past few years; and, that there’s a concern that dark pools “may have achieved this rapid growth in part through more favourable regulatory treatment.”
The paper says that this possible advantage stems from rules in the U.S. that prohibit exchanges from quoting in price increments of less than a penny for securities that are trading at least $1.00. This constraint can lead to a build up of a trading queue in the exchange’s order book. And, the research finds that traders can jump those queues by trading in a dark venue.
Indeed, the study concludes that there are “strong incentives for traders to migrate their order flow to dark venues to benefit from queue jumping when the stock is trading just above a dollar, which is immediately lost when the stock price falls below a dollar.”
To examine this phenomenon, it compares trading in stocks that are priced around the one dollar mark, and finds “a sharp rise in dark venue market share when the stock price rises just above a dollar.”
The study also suggests that, “Over time, the ability to queue jump on some dark venues can discourage traders from providing liquidity to traditional lit order books, resulting in wider spreads and less depth.”
In terms of policy, the CMCRC says that the study’s results support the possible introduction of a ‘trade-at’ rule, which would require that dark orders must be routed to lit exchanges unless dark pools can provide meaningful price improvement. These sorts of rules have been adopted by regulators in Australia and Canada, the paper notes. And, they are currently being studied by the U.S. Securities and Exchange Commission (SEC).
That said, the paper also notes that queue jumping and sub-penny pricing are only two ways that trading venues compete for order flow, they also compete based on various other features. “For regulation to evolve, we need a deeper understanding of how these trading rule differences affect intermarket competition, both individually and in combination, their impact on the competitive positions of alternative trading venues and their ultimate effects on the quality of capital markets,” it says.