How likely is it that political pressure will result in order size limits for dark pools?
Kay Swinburne, an influential member of European parliament for the Welsh Conservative party, has called for a European Commission (EC) investigation into how such limits could work. On 9 November 2010, a report she authored entitled ”Regulation of trading in financial instruments: dark pools etc.' was adopted by the European Parliament's Committee on Economic and Monetary Affairs. It asked that the EC examine the “effects of setting a minimum order size for dark pool transactions” and consider whether “it could be rigorously enforced so as to maintain adequate flow of trade through the lit venues in the interests of price discovery”. Michel Barnier, European internal market and services commissioner at the EC, cited the report as a source of inspiration.
Her concerns are twofold; fragmentation and trading in the dark both tend to damage price discovery and market transparency. A large number of trades that are made on an OTC basis, she says, would not require protection against market impact if the market wasn't fragmented. Forcing trades into lit pools will diminish fragmentation and dark trading volumes, alternative venues will fall away and price discovery and market transparency will be restored.
The paper for which Swinburne was rapporteur will serve as informal guidance ahead of the EC's MiFID II proposals, expected in Q2 2011, but the idea of order size limits in dark pools has not been put out to public debate explicitly in the commission's consultation on MiFID, which provides the formal basis of new legislation.
The Canadian regulatory bodies, the Investment Industry Regulatory Organisation of Canada and the Canadian Securities Administrators, also supported a size limit on dark orders in a position paper released on 19 November 2010. Posting small orders to a visible market and facilitating price discovery were “key components of fair and efficient capital markets”, the report asserted.
Is the US joining in?
No. In 2009 the US regulator, the Securities and Exchange Commission (SEC), proposed a number of measures that would affect the way that dark pools operate, but not a minimum order size. It has suggested lowering the threshold at which alternative trading platforms must display bids and offers to 0.25% of a stock's average daily volume from 0.5%, as well as real-time disclosure of the venue which executes a trade and bringing reporting in line with registered exchanges.
In 2010 it also proposed the ”trade-at' rule to encourage dark trades back onto lit venues. These have not yet been voted on, but the SEC will have more time to devote to the regulation of dark pools now that Dodd-Frank and the flash crash are no longer dominating the regulatory agenda.
How would a size limit work?
No definitive structure has been proposed for order size limits in Europe, although regulators in Canada have been more forthcoming. In their position paper they set out a series of proposed parameters for orders permitted in dark pools, including: no fewer than 50 shares per order (subject to market feedback); no aggregation of orders to qualify as dark; and no migration of a dark order to a lit venue, even if a partial fill brings the balance below the threshold.
In April 2010, a European size order limit was proposed by the Committee of European Securities Regulators, a pan-European regulatory body. Under the proposals a dark pool using the price reference waiver, which matches trades at prices based on those displayed at major venues, would be subject to an order size limit.
What effect would a size limit have on trading flow?
By forcing smaller trades onto lit venues, a size limit would obviously reduce the proportion of trading sent to dark pools. The quality of liquidity on dark pools would increase, but the number of opportunities would decrease. The many small orders generated by VWAP and implementation shortfall strategies would flow to the lit.
In the short term it could leave firms struggling to find matches for orders in emptier dark pools, until the number of trading venues reduced to a manageable size though economic pressure. In the medium term by reducing the number of trades made in the dark, a reduction in fragmentation could making it easier to find matches for large blocks.
Would that help price discovery?
Simply put, when all trading occurred on a single lit venue there was no problem with price discovery. So if that's your only objective, the answer is yes.
But there are two reasons, at least, for questioning the practical value to investors of the pursuit of greater transparency by politicians and regulators. Firstly the level of OTC trading that does occur is disputed, with some putting the figure at close to 40% of total European equities trading and others at nearer 10%. If we can't agree on how much trading has been lost to dark pools and other OTC channels, can we be sure of the benefits of pushing some of it back into the light?
The second is that price discovery is being tackled in the medium term by the mandating of a post-trade consolidated tape under MiFID II, which would supply a single source of pricing data across Europe's many trading venues, potentially including dark pools as the work of regulators and market participants to harmonise trade flags begins to bear fruit. With pre-trade transparency – the most significant difference between lit and dark venues – increasingly rendered meaningless by the growth of high-frequency trading, post-trade transparency might have been slow to develop, but we're nearly there!
As such it's hard to find market participants in favour of size limits. In Europe both buy- and sell-side commentators have expressed scepticism as to the value of the proposals. And the Investment Industry Association of Canada, a sell-side industry body, said it was “generally not in favour of the imposition of minimum size requirements” on dark pools, citing a lack of evidence that small orders impede price discovery and that intervention by regulators could have unintended consequences.
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