CFA Institute Report Cautions on Growth in Dark Pools

A report by the London-based CFA Institute has called on regulators to monitor the growth of so-called ‘dark pools’ of liquidity, where trading in stocks is away from lit public stock exchanges. The report urges traders to reveal more about their activities voluntarily, or face extra regulation.

The global, non-profit organisation for investment professionals states in its paper, entitled ‘Dark pools, internalisation and equity market quality’, that regulators should evaluate how dark pools affect price and market liquidity, and should monitor their growth. “Such disclosures would improve transparency and enable all stakeholders to better understand their relative benefits and drawbacks,” it adds.

The paper reviews the impact of dark pool trading on market depth and bid offer spreads; both metrics used to determine market quality. It concludes and that although increases in the amount of dark pool trading correlate with improving market quality initially, when more than 50% of a stock’s trading occurs in dark pool exchanges then the market quality deteriorates.

The ‘dark’ sector has received a considerable boost in Europe in recent years, following the Markets in Financial Instruments Directive (MiFID), which is currently being updated by the EU to take account of the changes it unleashed. The market changes brought about by stock exchange market liberalisation were first unleashed in the US.

The three main recommendations of the CFA Institute’s report are:

  • Internalisation of retail orders should provide a significant price improvement, thereby generating economically meaningful savings for retail investors, and providing some protection to investors posting displayed orders on public exchanges.
  • Regulators should monitor the growth in dark trading and take appropriate measures if it grows excessively.
  • Dark trading facilities should voluntarily improve reporting and disclosures around their operations, so that investors and regulators can make more informed decisions over their use.

The CFA reports that the volume of dark pool trading has increased by 48% since early 2009 and now accounts for around 33% of the total volume of trades executed in the US.

According to the paper’s author Rhodri Preece, director of capital markets policy at the CFA, it is likely that the figure for Europe is similar, post-MiFID. “The results suggest that dark trading does not harm market quality at its current levels but the gains are not indefinite,” he said.

“If the majority of order flow is filled away from pre-trade transparent markets, investors could withdraw quotes because of the reduced likelihood of those orders being filled. It would be prudent for authorities to monitor these developments closely.”

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