“Dark trading” proposals too hasty?

Finally, in July, the Canadian Securities Administrators and the Investment Industry Regulatory Organization of Canada proposed changes to the trading rules that are designed to allow dark trading to continue but aim to push it back toward its original purpose of facilitating large trades and to otherwise encourage trades to take place on traditional, “lit” exchanges.

Overall, the goal is to allow dark trading to flourish in circumstances in which anonymity is paramount but also preserve price discovery by ensuring that traditional, transparent trading takes precedence. Regulators fear that dark trading, if left unchecked, could drain liquidity from visible markets and erode market quality.

But many of the comments on the proposals warn that regulators are being too hasty in moving to curb dark trading, which also could hurt market quality.

Although there’s general agreement that regulators should prevent Canada from emulating the U.S. example, in which a proliferation of dark pools has severely fragmented that market, Canada’s financial services industry is also worried that the proposed rules will mean investors lose the benefits of dark trading and market quality will suffer as liquidity gravitates to less restrictive venues.

For example, TD Securities Inc.’s comment says that while the proposed rules probably won’t have a big effect on institutional trading, they will effectively eliminate retail trading in the dark, which now constitutes about 70% of dark trading volume — thereby reducing dark trading to less than 2% of overall trading volume from 6.5%.

Among other things, the TD paper suggests, the proposed changes would establish that visible orders must take priority over dark orders at the same price on the same market. They would give IIROC the ability to set a minimum order size for dark trades — although regulators are not actually proposing to impose a minimum right away. As well, the changes would require small dark orders to receive a minimum level of price improvement.

Echoing this concern, the comment from the Canadian Security Traders Association Inc. indicates that the move to establish minimum price improvement “will make the economics of providing liquidity to small orders in dark pools unattractive to most, if not all electronic market makers.” As a result, the CSTA comment continues, if the proposals are adopted, it probably means those small orders will disappear.

In addition, some industry players fear that clients will lose out. TD’s comment estimates that the availability of dark liquidity is currently delivering about $3 million in price improvement annually for its retail clients, which also results in larger trade executions than what’s available in the visible market about 10% of the time.

The CSTA comment adds that its main concern is that the changes to the availability of dark liquidity are being proposed “with no real evidence that it will ‘improve’ the situation in Canada.”

In fact, to some extent, regulators are in the dark here, too. They are trying to walk an uncertain line between recognizing the value of dark trading and risking that it displaces transparent trading, which is a hallmark of fair, efficient markets. Yet, there’s no clear agreement on how to handle these issues.

Indeed, as the CSTA comment acknowledges, its members couldn’t reach consensus; the only thing they can agree on is that regulatory decisions should be guided by data and the effect of regulations should be tested and, if necessary, adjusted, depending on how markets react.

If these proposals go forward, market players and regulators both will undoubtedly be keeping a keen eye on their effects on that ever-elusive market quality. IE