Trading in the Dark

The market has always had lit and dark elements, which serve equally important and valuable roles, but technology has changed how the two interact.

Extensive media coverage of dark trading in US equity markets has painted dark pools as shady, unscrupulous and bad for the market. But are the actions of a few distorting our perceptions of dark trading, which has always been part of a balanced equity market? Professor Carole Comerton-Forde, co-Deputy Head of Finance at the Faculty of Business and Economics, argues that dark pools play a legitimate and important role, delivering additional liquidity to the market. But, just like all markets, they need to be effectively regulated.

So, what are dark pools?

Dark pools are trading venues without any pre-trade transparency, allowing order flow to be submitted without being displayed in the market before the orders to buy and sell shares are matched. Dark pools were designed to allow institutions to trade large volumes without moving prices and undermining the traditional market function.

“Anticipation of large order flows driven by large institutional investors can distort prices,” explains Comerton-Forde. “Dark pools allow these trades to be made without unnecessarily impacting price discovery.”

The term ‘dark trading’ is relatively new – but its function is not. Historically, dark trading occurred in ‘the upstairs market’, where brokers would match large orders over the phone without any disclosure to the market. However, since the late 1990s technology has enabled automated dark trading, which means that brokers can offer dark trading for small as well as large trades.

"In the past, orders had to be large to be worth the manual effort to trade in the upstairs market," explains Comerton-Forde.

“Firms may still have larger orders to trade, but new technology has made it more efficient to trade in smaller quantities.

“A well-functioning market caters to the needs of different types of traders. Having lit and dark elements in the market enable investors to get their orders filled without large price impact, while at the same time ensuring there is adequate price discovery in the market. But it does add to market complexity.” 38


The truth behind the hype

The alleged misconduct by brokers in certain dark pools in the US isn’t about dark trading per se, says Comerton-Forde, but about the lack of transparency in the way brokers operate the dark pools. Dark pools operate under guidelines specific to that trading venue, which are not always transparent to users. For example, investors may send orders to a dark pool to avoid trading with high-frequency traders, unaware that these traders are also operating in the dark pool.

Problems arose in the US because there were no rules mandating the disclosure of the rubric of each dark pool.

Another concern, which receives significantly less public attention, is the level of dark trading activity in certain markets.

"One of the critical functions of a market is price discovery to enable investors to observe prices and understand what the price of the stock should be, explains Comerton-Forde. "Too much trading in the dark can harm price discovery."

This is particularly important with high levels of trading in small quantities, which research by Comerton-Forde and co-author Talis Putnins, published in the Journal of Financial Economics, found could be harmful to price discovery. By contrast, they found that large trades in the dark have no effect on price discovery.

Regulating the dark

Regulators in Australia and Canada have been more pro-active in regulating dark trading than those in the US. In order to reduce the level of dark trading, and to address the perceived unfairness of dark orders stepping ahead of lit orders at the same price, the Australian and Canadian regulators, ASIC and IIROC, introduced the price improvement rule, requiring that all small trades in the dark be executed at prices better than those displayed on the lit market.

ASIC also introduced new rules to enhance the transparency of the operation of dark pools, mandating that pool operators publicly disclose details of order types allowed and investor access criteria. In addition, the dark pool where they were executed must now be reported three days after the trade. ASIC is able to monitor trading activity in dark pools in the same way it does for the lit exchange trades.

But how effective is dark trading regulation? Comerton-Forde and two co-authors from the University of Toronto, Katya Malinova and Andreas Park, examined the impact of the introduction of the price improvement rule in Canada. Before the rule change, the largest dark pool in Canada allowed retail order flow to be matched in the dark. “Electronic liquidity providers in that dark pool were making a market and matching all of the retail order flow that came into the pool,” says Comerton-Forde.


The majority of retail order flow was going to this dark venue and electronic liquidity providers were earning most of the bid-ask spread. When the rule changed it was no longer profitable for the electronic liquidity providers to make markets in the dark because they could earn only half the spread. As a result, retail order flow was sent to the lit exchange market rather than the dark pool.

“There was more liquidity on the cheapest lit exchange, order flow went up and the good thing was that the order flow was available to everyone, not just the electronic liquidity providers in the dark pool,” says Comerton-Forde.

But, while order flow in the lit market increased, the retail brokers were now required to pay fees to send orders to the lit exchange, a cost they hadn’t incurred in the dark.

The regulation gave rise to another issue. In the new lit environment, most retail order flow is going to a single venue offering the cheapest fees, so although the retail order flow is now lit, it is still segmented in a single market.

“Markets work well when you have different types of order flow interacting,” explains Comerton-Forde. “The problem in Canada was not just about dark trading, but rather it was about retail order flow being segmented from other order flow.”

Misunderstanding about dark trading, driven by the misconduct of a few and widespread sensationalist journalism, is damaging to the market. Regulation is needed, but regulators need to be aware that not all dark trading is the same, and they need to be cautious to ensure the issues they regulate address the core problem.

Carole Comerton-Forde is Professor of Finance at the Faculty of Business and Economics, University of Melbourne. She is also an economic consultant for the Australian Securities and Investments Commission.