Regulators are often accused of being way behind the times and painfully slow to react as the financial services industry evolves. However, in the case of so-called “dark pools,” they are facing the opposite claim. Trading firms are worried that regulators are jumping the gun and moving too fast to clamp down on the dark liquidity phenomenon that has yet to do any harm.

Late last year, the Canadian Securities Administrators and the Investment Industry Regulatory Organization of Canada sketched out a joint position on trading in dark pools, or via “dark orders,” which don’t provide pre-trade transparency. Among other things, the consultation paper proposes to set a minimum size threshold for orders to be allowed to trade in the dark.

In effect, big orders would be able to trade in the dark, but small orders would not. The idea is to preserve the traditional justification for dark trading — allowing large, institutional investors to enjoy anonymity, enabling them to move large blocks of stock without telegraphing their intentions (along with various other possible benefits) — while protecting the primacy of conventional “lit” market trading, in which the vast majority of market activity still takes place.

In proposing to set a minimum size for dark trading, the regulators have indicated that while they recognize there can be benefits to trading in the dark, they also have concerns. For example, they worry that as strategies evolve and traders begin using these facilities for reasons other than moving large orders, these venues could attract ever greater shares of trading activity, drawing volume away from the traditional lit markets, both undermining the liquidity in those markets and gaining a free ride on the pricing information they provide.

Despite those concerns, many of the comments submitted on the regulators’ paper argue that it is premature to start imposing limitations on dark trading, which still accounts for only a very small proportion of the trading activity in Canada (around 2.5%, according to the latest IIROC data).

Says ITG Canada Corp. ’s comment on the regulators’ paper: “Given the relatively small percentage of current volumes trading in dark pools in Canada, and the fact that there is no evidence to support the concern that dark pools have a negative impact on market quality, we believe that there is no strong argument for any significant regulatory changes in the current Canadian framework.”

This view is echoed by the majority of comments, which point out that there’s no evidence that dark pools are harming market quality in Canada — and that jumping in to restrict the pools’ operations stifles innovation and could have other unintended negative consequences for the market. To the trading venues and buy-side firms that defend dark trading, it is just another tool that traders can use to get best execution for their clients. Without evidence that dark trading is harming markets, the comments warn, regulators should tread cautiously.

Some comments also point out that preserving the ability of large traders to conduct their transactions more anonymously may not be as simple as drawing a line between large orders and small ones. The Investment Industry Association of Canada’s comment indicates that, even in the dark, big orders may be broken up and traded in smaller portions; although an order may look small, it may be part of a larger strategy; and the regulators’ proposed approach could disrupt this: “By imposing minimum size requirements, the traders’ ability to develop tools and strategies that will best serve their clients may be compromised, leaving clients with something less than best execution.”

Moreover, firms worry that if regulators impose a minimum size on dark orders, this will effectively alert the market to the existence of large orders in dark pools, creating a number of negative consequences, such as giving other traders useful information about trading intentions, which would allow those traders to trade against these dark orders, making execution of the latter costlier.

The threat of this could, in turn, hamper liquidity, as traders decide to keep these sorts of orders out of the market altogether, trading internally or on the upstairs market instead. This could produce precisely the opposite result to what regulators intend, which is to keep volume on visible, public markets as much as possible.

TD Asset Management Inc. ’s comment cautions that the imposition of order size minimums could drive liquidity away from the visible market and away from domestic markets entirely for interlisted stocks. Moreover, small retail orders could lose the potential for better pricing as the opportunity to trade with dark orders is diminished.@page_break@The ITG comment agrees: “These proposals may create regulatory arbitrage for our interlisted issues and drive trading flow in interlisted issues south of the border. Some Canadian dealers have already suggested the possibility of selling or routing their interlisted flow to U.S. dark and crossing markets.”

However, the backlash against the regulators’ paper is not unanimous. Although the buy side and the dark pools themselves generally favour a hands-off approach by the regulators, a couple of the large brokerage firms have indicated that they support the plan to introduce some regulation in this area.

For example, Scotia Capital Inc. ’s comment says that while dark pools are a “valuable tool” for brokers and clients, the firm believes that it’s important to encourage the use of traditional, visible markets. And the comment suggests that the regulators’ approach to doing this is correct: “The CSA/IlROC recommendations strike a reasonable balance between allowing the use of dark pools for the matching of larger orders while limiting the development of internalization pools that have the potential to remove liquidity from lit markets and harm price discovery.”

The Scotia Capital comment adds that although the firm supports the notion of a minimum order size — as contemplated by the regulators — it suggests that the threshold should be based on the relative liquidity of a security rather than calibrating it simply by order size: “For example, a percentage of the averaged daily volume or a multiple of the average order size for the security may form an appropriate basis for the minimum size threshold.”

Similarly, RBC Dominion Securities Inc. ’s comment indicates that DS supports the idea of imposing a minimum size threshold. Although DS isn’t opposed to dark trading, its comment suggests that regulatory intervention is necessary to encourage trading in the visible markets “to counteract the increasing tendency of dark orders and marketplaces to ‘free ride’ on [pricing information] provided by visible orders.”

Not surprising, the traditional market vanguard, TMX Group Inc. , also supports the regulators’ efforts. Its comment argues that it is “critical that Canada’s market structure protects the value and quality of the visible book” by having regulation that doesn’t encourage dark trading over visible trading.

The TMX comment points to the U.S., where dark trading has proliferated to a greater degree (representing about 10%-12% of trading volume, according to some estimates, vs about 2.5% in Canada), and says that this trend has fragmented liquidity, imposing higher costs on the securities industry: “Although Canada currently has few dark venues in comparison to the U.S., it is imperative to recognize the potential for a significant amount of liquidity in Canada to ‘go dark’ as more facilities enter the Canadian market.”

In addition, the TMX comment calls on Canadian regulators to avoid a similar fate for our markets by taking action now: “The promotion of a strong and liquid visible market through regulatory policy will assist in pre-empting a similar fragmentation trend in Canada.”

As always, when it comes to setting rules in an area of the securities industry that is often viewed as a zero-sum game, there are strong, self-interested opinions on both sides of any issue. However, market players on opposing sides of the “dark order threshold” issue agree that there are complementary issues regarding market structure that they want to see addressed, too. Various comments say regulators should also be dealing with issues such as brokers internalizing their order flow, trading in the upstairs market, broker preferencing, the use of smart order routers and the use of “indications of interest” to attract trading activity.

“To consider any of these issues in isolation does not fully address the complexity of the trading environment,” notes the ITG comment, which warns that piecemeal regulation may have unintended consequences for market quality and integrity.

TMX is particularly concerned about dealers internalizing their order flow. Its comment warns that “a lack of adequate policy and oversight in this area will increase internalization activities, impair liquidity, increase spreads and increase volatility in the visible market.” And, it adds, anything that harms the quality and efficiency of the domestic market will also impair Canada’s global competitiveness.

On the issue of dark orders, regulators are trying to be proactive and avoid such harm, but some are worried they may be too eager to intervene. IE