Financial services industry regulation is always a bit of a balancing act among competing interests. The feat is particularly challenging in the world of equities trading, in which the playing field is in constant flux and the players are engaged in a fiercely contested zero-sum game.
This past autumn, regulators broached some of the thorny issues that are arising as the equities market structure evolves by kicking off a discussion of the impact of so-called “dark pools” on the Canadian trading landscape. The Canadian Securities Administrators and the Investment Industry Regulatory Organization of Canada have jointly released a discussion paper soliciting input from the industry on a variety of issues that accompany the emergence of dark pools of liquidity in the Canadian market.
The deadline for submissions on these issues was the end of last year, and the topic has sparked plenty of feedback from a broad spectrum of market players, including brokerage firms, money managers, traders and trading venues. Amid all the various responses, there is relatively little consensus — both in terms of the significance of the dark pool phenomenon, and on the sort of actions that regulators should be considering to accommodate it.
To be sure, dark pools are currently a marginal feature in the Canadian market. When the paper was published, dark pools accounted for less than 1% of market volume. However, many market-watchers expect this share to grow rapidly in the years ahead, and there is concern among some that if dark pools flourish without adequate regulation, that could have some negative consequences for the market overall.
Some see dark pools as an emerging threat to market fairness and just another way for big firms to exploit their market power at the expense of smaller players. Critics argue that dark-pool trades represent free rides on pricing information supplied by orders that are exposed to the traditional, visible exchanges. Moreover, the critics contend, these venues aren’t subject to the same sorts of rules and restrictions that govern traditional exchange trading, leaving dark pools more open to exploitation by very aggressive or technologically sophisticated traders at the expense of smaller players.
Yet other market players regard dark pools as an important innovation that improves overall market efficiency. Advocates argue that dark pools are at least neutral to the price-discovery function, and even beneficial in some cases.
For example, Toronto-based Alpha Trading Systems Ltd. points out in its submission that dark pools may improve price discovery in situations in which dark pools attract trading volume that would otherwise have been moved in the “upstairs” market, which, combined with the fact that dark pools must report post-trade information, gives the market more information than it is likely to have had otherwise.
Views on this issue appear to be somewhat divided along industry-sector lines, depending on whether you sit on the “buy” side or the “sell” side. The Canadian Security Traders Association Inc. surveyed 269 traders to get their response to the issues raised in the regulators’ paper (the results of which are reported in the CSTA’s submission on the consultation paper) and found that in some areas, traders on both sides of the Street are generally in agreement, while on others, there’s a basic difference of opinion.
The effect of dark pools on price discovery is one of the issues on which survey respondents disagreed, with buy-side traders suggesting they increase liquidity and lower transaction costs by attracting volume that would otherwise be executed in the upstairs market. Conversely, sell-side traders generally took the position that much of the trading that occurs in dark pools would otherwise be transacted on a visible market; so, hiding those orders impedes price discovery.
The TMX Group Inc. submission indicates that in a market dominated by a few large dealers, price discovery is in particular danger if dark pools manage to attract a significantly larger share of trading volume: “The existence of one large dark pool or a combination of dark pools in Canada could ultimately result in widening bid/ask spreads and diminished price discovery on displayed markets if these dark pools are utilized by a few major Canadian dealers. The CSA must recognize the vulnerability of the Canadian market to possible erosion of our central price discovery mechanism if these large dealers begin to interact with dark pools in Canada in any significant manner.”
@page_break@Not surprising, some of the larger dealers have a different view. In its comment, CIBC World Markets Inc.’ s comment suggests that regulators’ efforts to integrate dark pools in Canada and the U.S. have focused too much on constraining them and preventing them from becoming “too large.” Far from harming market quality, the CIBC World Markets note says, “Artificial constraints on a structure that provides real value to the market will create missed opportunities and reduce efficiency, particularly in Canada, where dark pools can significantly contribute to price discovery by providing ex-post information to the market.”
Rather than restricting dark pools, the regulators should be focused on expanding access to these pools, the CIBC World Markets note suggests, adding that a combination of dark and visible markets is preferred: “Total liquidity and narrower spreads are better achieved in a mixed environment of lit and dark markets.… The trade-off between price improvement and immediacy leads to innovation by participants, makes new strategies possible and drives competitive innovation by marketplaces.”
The Investment Counsel Association of Canada’s comment also comes out strongly in favour of dark pools: “[They] serve an important function in the marketplace” and help achieve best execution.
Additionally, the ICAC’s note suggests that the availability of dark pools will help attract foreign investors to the Canadian market. “Global investors have in the past viewed Canadian securities and markets as too illiquid,” the ICAC note says, adding that increased trading by foreign investors should increase the size of the overall market and dark pools’ share of that market.
However, the ICAC’s note does express concern with another market innovation that isn’t covered in the regulators’ consultation paper: high-frequency trading. The ICAC comment says that this sort of trading is “the biggest risk today,” and is something that regulators should address.
Indeed, several comments advise that the regulators should be dealing with market structure issues that go beyond just the rise of dark pools, highlighting the dilemma facing regulators when it comes to tackling areas of market innovation — they can be simultaneously considered both too early and too late on an issue.
The comment from Toronto-based TD Securities Inc. , for example, says that, given the tiny share of daily volume that is currently executed in dark pools: “It is too soon to act with regulatory changes in this space.” The TD note suggests that Canada is just in the third inning of a nine-inning game on such market structure changes.
Yet, at the same time, the TD note argues that dark pools are old news in this fast-changing part of the industry: “While it may have seemed in late 2008 that dark order types and dark pools were the most important hot-button market structure items for regulators to investigate, by the time the report was published in late 2009, the emergence of high-frequency trading/electronic market-making and sponsored access were arguably more controversial and topical than the growth in dark trading. As a result, by the time it was published, the report was out of date and covered only a narrow part of the changing market structure landscape.”
This stance is echoed by the Investment Industry Association of Canada, whose comment warns that the regulators’ paper is a bit stale and that regulators must be working with the latest information or the “regulatory framework risks being incomplete, inappropriate and causing unintended consequences and incurring excessive compliance costs.”
The IIAC comment suggests that this is what happened when regulators last tried to grapple with these sorts of issues, creating rules to accommodate alternative trading systems. The IIAC note says that regulation lagged behind the market’s evolution in that situation and, as result, left the industry bur-dened with “inappropriate and expensive regulation.”
To avoid a repeat of that experience, the IIAC note calls on the regulators to create a committee of experts, drawn from the regulators and the financial services industry, to monitor these issues and recommend regulatory responses.
The regulators have promised to hold a roundtable to discuss the issues raised by the consultation paper. The Ontario Securities Commission indicates that the date for that session has not yet been set but that “the comments received are currently being reviewed, and participants will have the ability to discuss the issues raised in the consultations.”
Certainly, the U.S. Securities and Exchange Commission has decided that the time is right for comprehensive review of market structure issues. In mid-January, it published a “concept release” that initiates a complete review of these issues, including dark pools, high-frequency trading, co-locating trading terminals, market-quality metrics and fairness. That paper is out for a 90-day comment period, after which the SEC will decide whether it needs to make any other rules to respond to emerging market structure issues.
The SEC has already started to address some of the concerns raised by high-frequency trading: last year, it proposed a ban on “flash” orders; in early 2010, the SEC proposed a new rule that would restrict direct market access.
Whether Canadian regulators decide it’s also time for them to put a thumb on the trading scales remains to be seen. IE
Dark pools ignite debate
There’s little agreement among industry participants about policing the pools
- By: James Langton
- January 26, 2010 January 26, 2010
- 10:26