Brokers make case against dark order size limits

Warnings about the negative effects of size thresholds for dark orders on execution performance - made in response to the MiFID II consultation conducted by the European Commission - have been supported by broker research.
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Warnings about the negative effects of size thresholds for dark orders on execution performance – made in response to the MiFID II consultation conducted by the European Commission (EC) – have been supported by broker research.

In its consultation paper, the EC highlighted that increased use of dark pools could affect price discovery and merited ongoing observation by regulators. The paper asked for feedback on whether a size threshold should be applied to orders that use the reference price waiver, i.e. dark multilateral trading facilities (MTFs) that derive their prices from displayed reference markets. The threshold would be intended to limit orders that did not risk market impact from trading in the dark.

Prior to the consultation phase, which ran from 8 December to 2 February, MEP Kay Swinburne published an own-initiative paper on behalf of the European Parliament, which suggested that all dark transactions should be subject to size limits, arguing that increasing levels of dark trading negatively impacted price formation.

According to Thomson Reuters' Equity Market Share Reporter, dark MTFs such as NYSE Euronext-owned SmartPool and Chi-X Europe's Chi-Delta, traded €23 billion in January 2011, more than double January 2010's total of €10 billion.

The European Parliament will be responsible for approving the new version of MiFID with the European Council once the EC makes legislative proposals in Q2 this year.

However two new papers, one from global broker Credit Suisse and another from agency broker ITG, caution against the notion that dark trading harms price formation and against the introduction of a size limit on dark orders. The papers formed part of the firms' respective submissions to the EC's MiFID II consultation.

Discovering prices

In a piece of research entitled ”Measuring dark pools' impact', Credit Suisse analysed the different effects of dark and lit trading on price discovery using three measures. The study was based on trades reported to Markit BOAT, but did not include large trades or those executed outside of the bid and offer spread.

“There are certain negative qualities attributed to dark pools, such as damage to price discovery,” said Mark Buchanan, director, portfolio strategy, Europe at Credit Suisse and co-author of the report. “A lot of debate in this area is purely subjective, so we sought to clearly define price discovery before conducting our analyses. Our goal is that it marks a turning point in the quality of the debate, with arguments for and against dark pool trading based on quantitative measures.”

The three measures used as a proxy for price discovery were: short-term volatility, i.e. how quickly markets digest information, with lower volatility linked to more efficient markets; variance ratio, which measures the degree to which price movements are random, with the assumption that fewer random price movements are indicative of less efficient markets; and return autocorrelation, which measures the relation of price moves to previous price moves, with a high autocorrelation implying a slower correction to balanced stock prices.

On this basis, the paper found no statistical evidence to show that price discovery for stocks was negatively affected by when they were traded in the dark; in fact, there was evidence to show that some stocks with a higher percentage of dark trading corresponded to better market quality.

The paper also analysed the execution quality of small child orders traded in the dark compared to large institutional orders.

Smaller dark orders provided a price improvement of 3.3 basis points versus lit markets using an implementation shortfall benchmark and 0.8 bps of price improvement against a VWAP benchmark.

The price of the dark

In separate research titled ”ATSs in Europe: Post-MiFID performance', ITG looked at the transaction costs of using dark multilateral trading facilities (MTFs), compared to lit MTFs and exchanges.

The study analysed nine dark pools, four lit MTFs and registered exchanges over the first ten months of 2010 and found that dark pool trading cost 13% less compared to regulated markets and 18% less compared to MTFs. However, most dark pools did not provide a significant level of price improvement for huge cap stocks.

The results for dark trading were not as positive as 2009, but the paper attributed this to new dark MTFs which had launched since the end of 2009 and that were acting as a “drag” on existing players.

According to the paper, the better performance of regulated markets compared to MTFs was also evidence that increasing dark pool trading had not harmed liquidity provision in lit markets in terms of costs.

Both ITG and Credit Suisse's studies suggest that dark trading does not have a detrimental impact on market quality and that regulators should think carefully before making any policy changes.

“With no evidence to suggest that dark pool trading is damaging either price discovery or market quality in general, introducing legislation to limit its use risks increasing execution costs with no discernible benefit to the market or end investors,” read the Credit Suisse research.

Similar views on the restriction of dark trading with size limitations, were also aired in various responses to the EC's consultation.

“We are not convinced there is a justifiable reason to apply a minimum order size, as this is contrary to the purpose of the waiver,” wrote Mark Hart, managing director at broker trade body the Association for Financial Markets in Europe, in its EC response. “No detail is provided, to support its detrimental impact on competition, which is an important element of the current regime that must be maintained to provide in user and investor choice. The waiver is an important tool allowing broker/dealer discretion on how sizing of orders is carried out to avoid adverse market impact and should be retained.”

“We oppose the application of a minimum order size without any explicit rationale or justification and believe it would harm investors' pursuit of best execution without delivering sufficient benefits in respect of transparency and resiliency of price formation,” read the response from the London Stock Exchange.