The American market has approximately 300 different venues, including thirteen registered exchanges, forty or so active alternative trading systems (ATSs) and numerous broker-dealer platforms.
“The extent of fragmentation in the United States outstrips anything we see elsewhere, although Europe isn’t that far behind,” CMCRC chief executive officer Professor Mike Aitken said.
The study, by Dr Frank Hatheway, Dr Hui Zheng and Dr Amy Kwan focused on US trading venues with restricted access and without displayed orders - more generically known as ‘dark pools’. These trades are often off the radar and are not displayed on public exchanges, accessed instead through separate cross networks.
It has traditionally been argued that as these are off the radar, they do not “cause” any harm to the market. However, the authors found that there were effects on order segmentation by dark venues, which damage overall price discovery and market quality.
More specifically, the researchers argued it did this by having more flexibility to offer sub-penny tick sizes and by traders being able to execute different restrictions on pre-trade transparency than others exchanged on more open platforms. Finally, black trades are also often exempt from fair access rules and can prohibit or limit access for certain users.
All these features, the authors stated, can “actively entice orders unrelated to the short-term directions of future price movements away from primary markets and this activity results in higher transaction costs across all venues, and lower price efficiency overall”.
The researchers recommended that there be changes to access requirements within the market to improve liquidity.
“We recommend the fair access requirements be modified and the five per cent threshold of exemption from lit market regulations be reduced,” Dr Zheng said, adding, “This would address the price inefficiencies arising from lack of liquidity provision competition within dark pools, and their collectively significant impact on US markets.”
In addition, the group thought a harmonisation of tick sizing would prevent market efficiencies occurring from dark patches.
“Dark venues are able to offer sub-penny executions, which allow them to attract uninformed orders by offering minimal price improvement,” Dr Zheng pointed out, adding, “More consistency across venues in tick sizing will remove some of the attraction.”
Some of the efficiencies could be implemented via regulators demanding that dark venues demonstrate a “meaningful price improvement” and also by “looking at ways to effectively prioritise lit orders”.
More broadly, the CMCRC believes research in these shadowy areas of the markets provide a useful guidance to legislators and market participants.
“The fact that this huge level of complexity results in poor results for investors shouldn’t be a surprise to anybody. The bigger question is what to do about it? Research like this is important in defining the issues and is a vital plank in developing evidence-based policy to address them,” Professor Aitken said.
