Increased pressure to establish clarity in dark trading, both on and off exchanges, is needed to restore confidence in US lit markets, a report has warned.
The increasing use of dark venues to trade large blocks of liquidity will spark serious industry-wide discussions on the quality of lit markets, the report from consultancy TABB Group cautions.
More than 30% of equity trading happens off-exchange and is reported to the trade reporting facility (TRF) operated by Nasdaq OMX, with 40% of publicly traded securities on tapes A, B and C, having TRF trading volume in excess of 40% in September 2012.
Miranda Mizen, a TABB principal and director of equities research, authored the research and believes the majority of off-exchange trading occurs in the most liquid, highly capitalised securities.
The combination of increased dark trading and fragmentation has added complexity to the trading landscape and institutional investors moving large block trades are increasingly aware of the lit market's shortcomings.
With statistical arbitrage traders forcing buy-siders to break up large blocks into small orders across multiple venues, lit markets could increasingly become destination of last resort, the report foreshadows.
“We believe regulatory action lies ahead but for it to be effective, any scrutiny of dark execution off-exchange must equally examine dark execution on-exchange, grounded in data and measured against benchmarks of fairness and efficiency,” Mizen said. “This is a question of how different and similar activity and execution alternatives should be regulated and fit together."
The report seeks to ask three pertinent questions related to the debate – namely does the protected quote need better protection, should off-exchange trading criteria be established and whether or not there is adequate transparency around dark trading.
“Many market participants believe the equity markets are now too fragmented and too opaque, and dark pools contribute to this. As dark execution comes under the microscope as part of the broader market structure debate, we believe the rules surrounding off-exchange trading in US equities will change,” the report reads.
Titled 'A spotlight in the dark: An inevitable debate', the report suggests further industry initiatives to establish clearer rules on dark trading will restore quality of lit markets for the benefit of the wider financial system.