Capital Markets Cooperative Research Centre (CMCRC), the Australian independent academic centre for capital market research, has found that segmentation to the extent that it has experienced in the U.S. has led to a deterioration of market quality.
The U.S. market features approximately 300 different venues, including thirteen registered exchanges, forty or so active alternative trading systems (ATSs) and numerous broker-dealer platforms.
The study, by Dr. Frank Hatheway, Dr. Hui Zheng and Dr. Amy Kwan, looks at U.S. trading venues with restricted access and without displayed orders - generically ‘dark pools’ – which increasingly segment order flow in the U.S. The study seeks to quantify the effect of dark pools on price discovery, and their impact on U.S. market quality. The authors show that the effects of order segmentation by dark venues are damaging overall price discovery and market quality.
Dark pools have more flexibility to offer sub-penny tick sizes, and different restrictions on pre-trade transparency. They are also exempt from fair access rules and can prohibit or limit access for certain users. These features differentiate them from lit markets such as exchanges and MTFs and provide dark pools additional constructs to attract order flow. However, the study argues that these features also allow them to actively entice orders unrelated to the short-term directions of future price movements away from primary markets and that this activity results in higher transaction costs across all venues, and lower price efficiency overall.
These findings contradict some common beliefs that dark orders have no negative spillover effects on the broader market. It is the special role of lit markets to set the benchmark of all order executions in the U.S. which serves as the transmission mechanism for dark trading to have a deleterious effect on the U.S. markets overall.
This study also addresses a common technical issue present in similar types of research, namely ‘"correlation’" vs. ‘"causality.’" In simple words, correlation means two events are related to each other, while causality suggests that it is one event that leads to the other. To disentangle between the two types of effects, the study utilizes a widely employed technique which confirms that dark trading is the causal agent for reduced market quality, not simply correlated with it and not the other way around.
The study does differentiate between small and large trade sizes, and stresses that block trading on non-NMS venues does not detract from market quality.
CMCRC CEO, Professor Mike Aitken, said the study confirmed what many already suspected about the state of U.S. markets.
“The extent of fragmentation in the U.S. outstrips anything we see elsewhere, although Europe isn’t that far behind,” he said. “The fact that this huge level of complexity results in poor results for investors shouldn’t be a surprise to anybody. The bigger question is what to do about it? Research like this is important in defining the issues and is a vital plank in developing evidence-based policy to address them.”
Professor Aitken notes that the proponents of dark trading generally consider the absence of discernible harm to the market as a whole as sufficient grounds to continue the practice. The alternative position is that dark trading should only continue if there is discernible benefit to the market as a whole.
However, discernible harm or benefit has to be seen in the context of the universal mandate of regulators (the party who is charged with arbitrating the dispute), which is to ensure that markets are fair and efficient. The implication of this mandate is very specific - dark pools must not adversely impact either efficiency or integrity. The article clearly shows that, with the exception of the block trading, efficiency has been negatively impacted through higher transaction costs and lower price discovery so the answer seems obvious. Dark pools (on average) have adversely impacted the efficiency of the marketplace with the fairness question an open issue at this stage.
Dr. Zheng said the group had made three key policy recommendations to address the problems highlighted in the report.
“Firstly, we recommend the fair access requirements be modified and the 5% threshold of exemption from lit market regulations be reduced,” he said. “This would address the price inefficiencies arising from lack of liquidity provision competition within dark pools, and their collectively significant impact on U.S. markets.
“Secondly, we recommend a harmonization of tick sizing. Dark venues are able to offer sub-penny executions, which allow them to attract uninformed orders by offering minimal price improvement, so more consistency across venues in tick sizing will remove some of the attraction.
“Finally we conclude that regulators should demand that participants demonstrate meaningful price improvement as a result of their dark executions, and look at ways to effectively prioritize lit orders.”
An Empirical Analysis of Market Segmentation on U.S.Equities Markets
An Empirical Analysis of Market Segmentation on U.S. Equities Markets - Appendices