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A Spotlight in the Dark

A Spotlight in the Dark

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TabbFORUM Commentary

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Published by: tabbforum on Dec 13, 2012
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A Spotlight in the Dark:
An Inevitable Debate
Miranda Mizen | V10:041 | November 2012 |www.tabbgroup.com
GlobalEquities
 
 
 
2012 The TABB Group, LLC. All Rights Reserved. May not be reproduced by any means without express permission. |
2
 
A Spotlight in the Dark: An Inevitable Debate | November 2012
Vision
It is clear from the hearings in Washington, SEC investigations, academic publications
1
andwater cooler conversations that at best, the US faces a severe image problem. We believethat the
industry’s
ongoing market structure debate will lead to regulatory changes. Everymajor development we have seen since Regulation NMS is under review. High frequencytrading, algorithmic trading, exchange order types, maker/taker pricing and dark pools haveall brought both benefits to a market place now struggling with the cost and complexity of fragmentation and a lack of transparency into how the market really works.TABB Group believes that there is overwhelming evidence that US equity markets are moreefficient for retail and institutional investors today than ever before. Spreads havenarrowed. Market impact has been reduced. Commission rates have declined. However,because so many changes have occurred over such a short period, it is hard to assigndegrees of attribution, and there are significant costs in linking to and finding liquidityacross dozens of execution venues.While the statistics have improved, a glaring number of high-profile market problems hasmarket participants concerned. Three dark pools have come under fire for disclosure issues,
two disastrous IPOs; Knight’s trading debacle; and
there is controversial debate over someexchange order types. These events then bring into question the very rules that governmarket structure, including the eroding difference between the roles of exchanges andbrokers.This research piece looks at one component of the larger debate and continues ourexploration of issues that include high frequency trading, market data, investor confidence,and the impact of market structure on the investor community. Here, we put the spotlighton one of the more contentious debates around trading in the dark and we inquire into darkexecution on- and off-exchange. Like it or not, we believe the rules surrounding off-exchange trading in US equities will change
it is only a matter of time. Already,regulators in Canada, Europe, Australia, Asia and Latin America have acted, swinging themarket structure pendulum in favor of transparency and consolidation.Dark execution exists in many forms both on- and off-exchange. Off-exchange, market-makers match and better the NBBO, offer risk capital on demand or in the form of actionable IOIs, and negotiate trades between natural buyers and sellers. AutomatedTrading Systems (ATSs) outnumber the lit exchanges by about 3:1, and incorporateinstitutional, retail, and high frequency flow. Their l
evels of ‘darkness’ var
y, as a number of 
1
 
See:
 “
Internalization and Market Quality in a Fragmented Market Structure
” 
by Daniel Weaver, Rutgers BusinessSchool ( July 2011);
 “What’s Not There: The Odd
-Lot Bias in TAQ Data
,” 
 
by O’Hara, Yao and Ye
(July 2011);
 “
DoDark Pools Harm Price Discovery?
” 
by Haoxiang Zhu, MIT Sloan School of Management (July 2012)
; and “DarkPools, Internalization and Equity Market Quality” by Rhodri Preece, CFA (October 2012).
 
 
 
 
2012 The TABB Group, LLC. All Rights Reserved. May not be reproduced by any means without express permission. |
3
 
A Spotlight in the Dark: An Inevitable Debate | November 2012
ATSs broadcast indications of interest (IOIs) or order solicitations or have links to otherdark pools. The use of dark and undisplayed orders also on the exchange order booksessentially makes the difference between dark execution on- and off the exchangesprimarily one of regulatory framework rather than a debate over dark versus lit. These allrepresent unique and valuable execution strategies, and there is danger in tarring all darkactivity with the same brush. Any review must consider both environments.While the number of platforms is still growing, some believe that the market is starting tofind its own equilibrium. The buy side asks more questions and exerts greater control thanbefore over what happens to their orders and trading counterparties. Others in the industrystill expect more dark trading growth as the large brokers consolidate order flow and someattract more high-frequency trading into their venues alongside institutions and retail.When discussing the topic with brokers, we hear some are reassessing their dark strategiesand planning how to compete in a changing regulatory environment that favors a moreregulated, transparent model.Market structure confidence in the US is low, one-third of US equity trading is executed on anon-exchange venue, and the makeup of this volume lacks transparency. Concerns over thelevels of off-exchange trading and fragmentation are tempered with the worry aboutunintended consequences and lack of alternative safe places to trade. Already there is livelyrhetoric about market structure across the industry, and it is probably only a question of time before the SEC starts the consultation ball rolling again on a number of marketstructure issues. Dark execution will be one of them.

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