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Equity markets are undergoing nothing short of a competitive revolution. Equity Market titans such as the NYSE, the London Stock Exchange, NASDAQ, Deutsche Borse and Euronext now share the limelight with dozens of players.
This revolution came about because regulators thought that competition would improve the efficiency and fairness of the markets. An important question therefore is whether competition is achieving these goals. In the U.S. market, where competi- tion is at its most intense, the answer is that one type of competition fails to pass the test.
In the U.S. it is now possible to trade stocks at 300 different venues of which only 13 are exchanges, the rest are broker operated Alternative Trading Systems and other broker operated systems which are known as “dark pools” and account for over 35% of share volume traded in the U.S. The expansion of this off-exchange trading (dark trading) so that they are able to offer an alternative to exchanges for orders of all sizes and types was an important innovation implemented by regulators in the hope that fragmented markets would help improve the quality of their markets. Has this significant expansion of market fragmentation achieved this? A recent study sought the answer to this very question, and the conclusion is no.
Dr. Hui Zheng and Dr Amy Kwan have found that in general dark pools harm mar- ket efficiency and lead to increased transaction costs and diminished price discovery due to the previously under-explored “cream skimming” effect on the benchmark prices provided by exchanges. Dr Zheng estimates that the loss in efficiency from ten per cent of trading moving to dark pools from traditional exchanges represents $23 billion in increased transactions costs in the US equities markets every year. The only exception is that the execution of block trades off-exchange continues to result in improved market efficiency.
Dr Hui Zeng Senior Lecturer, University of Sydney
In terms of fairness it remains an open question whether this has improved in the wake of competition. However, Dr Zheng suspects not as there is no centralised surveillance authority in US markets, leaving open the distinct possibility of cross- market abuse, including insider trading, market manipulation and front-running. In light of the fact that there are no client identifiers on orders and brokers are not required to tell you when they are trading as principal and agent, there are grave concerns about the impact of competition on the fairness of the US market.
Dr Amy Kwan, CMCRC PhD Graduate, University of NSW
It doesn’t appear that the current level of fragmentation brings fairer or more ef- ficient markets in the U.S. So the next question to ask is whether regulators should restrict this type of trading to block trades only and whether any lost individualisa- tion would be offset by markets having become fairer and more efficient.
The Capital Markets Cooperative Research Centre is a world-leading research organisation that provides thought leadership and break-through technology solutions for capital and insurance markets (www.cmcrc.com).
