US regulations could be providing dark pools with additional advantages that have made them more popular at the expense of lit venues, according to research from the Capital Markets Cooperative Research Centre (CMCRC).
In its latest published paper, CMCRC said Regulation National Market System (RegNMS) developed by the Securities and Exchange Commission (SEC) provides traders in dark pools with the ability to circumvent time priority, creating an unintended benefit to trading on these venues.
Its research found unusual trading activity at around the US$1 level. As stocks drop below US$1, minimum pricing increments decrease from US$0.01 to US$0.0001. CMCRC says there is a strong incentive for flow to migrate to dark venues once this threshold is reached in order to benefit from the ability to “queue jump” by avoiding time priority rules.
Because dark venues are able to offer sub-penny price increments and are not required to route orders to venues setting national best bid and offer quotations, CMCRC argues that this tactic effectively enables dark pools to trade ahead of displayed limits orders with little or no price improvement.
Amy Kwan, author of the paper, said, “Our study found a sharp rise in dark venue market share when stock prices are just above the US$1 level. The effect isn’t constrained to penny stocks – high prices stocks exhibit similar behaviours.
“We also see that on trading days when stocks are severely constrained by the minimum pricing increment, dark venues gain market share as well.”
The CMCRC study of US dark pools found their market share in stocks trading just above the US$1 level is almost double that of those just below.
Kwan adds that the research demonstrates the distorting effect that minimum pricing increments can have on the market, and support calls for an introduction of a ‘trade at’ rule.
The SEC is currently investigating implementing a ‘trade at’ rule, which would require dark pool trades to achieve meaningful price improvement to discourage high-volume, small trades from taking place outside the lit market, theoretically improving price discovery.
“Requiring dark orders to be routed to lit exchanges unless dark pools can provide meaningful price improvement would support depth and tighten spreads on the lit markets, which in turn is positive for price discovery, which, after all, is what markets were designed for originally,” Kwan said.