US regulator the SEC supports circuit breakers

The CMCRC is concerned that dark pools have an advantage

Trading rules in the US are giving dark pools an unfair advantage over exchanges and could be damaging liquidity, according to a new report by the Capital Markets Cooperative Research Centre.

Dark pools are trading venues where the participants remain anonymous until after a trade has been completed. The idea is to protect participants from market impact by shielding their identity – making it easier to trade a large block of stock. Dark pools have gained in popularity in recent years, and now account for about a third of total shares traded in the US, according to the CMCRC.

However, their rise has been accompanied by controversy, as detractors of dark trading argue that the practice undermines price discovery and threatens the transparency of the stock market. The CMCRC’s core complaint in its report, Trading rules, competition for order flow and market fragmentation, is that the tick size rules that apply to exchanges in the US unfairly disadvantage them versus the dark pools.

In the US, exchanges cannot provide prices in increments below a penny unless a stock falls below $1. The study points out that dark pools are profiting from this minimum tick size requirement, which was introduced by Reg NMS in 2005, because long queues of displayed limit orders can build up for some stocks where there is high demand.

But traders can bypass these queues and reduce their risk of delayed execution by using a dark pool, because the dark pools don’t have to follow tick size rules and can offer prices in sub-penny increments. This means that trades in the dark can effectively jump the queue and trade first.

The report adds that there is strong demand for tighter tick sizes in many highly liquid stocks, and that price discovery is now taking place in off-exchange venues when bid-ask spreads on traditional exchanges are constrained by government regulation. This situation can be disastrous for lit markets, because the ability to queue jump on some dark venues discourages traders from providing liquidity on the traditional stock exchanges, resulting in wider spreads and less depth.

“As more order flow migrates to dark pools because of the minimum tick size regulations, the probability of execution in dark pools rises, which encourages more traders to submit their orders to these trading venues,” said the report. “This positive feedback loop in liquidity, initially triggered by minimum pricing requirements, is an important factor driving order flow off the exchanges and encouraging the rapid growth of dark venues.”

Dark pools have been under regulatory scrutiny for several years. However, in recent months the issue has gained renewed publicity. In June, New York state attorney-general Eric Schneiderman sued Barclays, claiming that the bank had misled investors by allowing predatory high-frequency traders access to its dark pool, and then marketing that pool to investors as a ‘safe’ haven.

One of the main reasons long-term investors trade in the dark is the perception that the lit markets are unsafe due to the presence of predatory HFT. The belief that dark pools such as Liquidnet offer a safer alternative is widespread among traditional asset managers. However, the bank-operated dark pools are now under greater scrutiny, and the investigation into dark pools has since been expanded to UBS and Deutsche Bank.


Other countries have attempted to impose restrictions and controls on dark trading in an effort to balance its possible benefits to the investor against perceived threats to transparency and the competitiveness of exchanges.

In Australia and Canada, regulators have attempted to ensure a level playing field for dark pools and exchanges by requiring a minimum level of price improvement for dark trades. However, the CMCRC notes that other features, such as pre-trade opacity and exemptions from fair access requirements still provide dark pools with an advantage. The organisation is calling for more study into the effects of applying different rules to dark pools and exchanges.