1. Regulation of dark trading: A tale of intended and unintended consequences Sean Foley (University of Sydney) Tālis J. Putniņš (UTS, SSE-R) CIFR Investment Management and Markets Conference 24 May 2016

2. Dark trading is high on regulatory agenda Why? – Rapid growth in US/Canada/Europe/Australia – Could be bad for markets … mixed evidence – Complaints by exchanges and market participants Many regulators have expressed concerns and made proposals, but are yet to implement Only two have implemented regulation to date – Canada, Oct 2012; Australia, May 2013 – We examine what we can learn from these two cases

3. The regulation Dark trades are required to provide a minimum level of price improvement over the best lit quotes – One full tick, or midpoint (1/2 tick improvement) – Previously: negligible/no price improvement in CA/AUS Objectives? – Decrease dark market share – Increase dark trade sizes – Improve Liquidity – Improve price discovery – Improve Fairness

4. Two types of dark trading Two-sidedOne-sided Three differences 1.Execution probabilities 2.Information revelation 3.Profitability of dark market making Resting dark SELLs Resting dark BUYs NBBO

5. Execution probability for impatient orders Resting dark SELLs Resting dark BUYs NBBO Impatient BUY Impatient SELL Impatient BUY

6. Execution probability for impatient orders One-sided (but not two-sided) dark markets cause order imbalance spillovers to lit market  One-sided dark venue executes some of the balanced but none of the unbalanced order flow Balanced order flow subsidizes costs of executing unbalanced (e.g., inventory risk, adverse selection)  A smaller volume of balanced order flow  higher charge per unit of balanced order flow to cover costs of imbalance (Zhu,2014)  One-sided dark venue can increase lit spreads (Hendershott and Mendelson, 2000) One-sided more harmful to liquidity than two-sided SELLs BUYs IMBALANCE BALANCED One-sided dark venue executes Lit venue gets

7. Information revelation Resting dark SELLs Resting dark BUYs NBBO 2. Recent executions 3. Probing orders One-sided reveals dark order imbalance  provides information about trading intentions: 1. Resting in the dark

8. Profitability of dark market making Positive dark spread Zero dark spread  Dark market making can be profitable in two-sided dark markets (but not one-sided)  This encourages competition amongst lit market makers (Boulatov and George, 2015) Resting dark SELLs Resting dark BUYs NBBO

9. But what does this “tale of two types” have to do with the regulation?

10. Answer: Regulation forced substitution between the two types UnconstrainedConstrained Before After

11. So – What happened?

12. Large and instant decline in dark volume CA: 9.7%  7.9%. AU: 17.6%  10.9%.

13. Dark trading forced almost entirely to mid Midpoint: CA 33%  97%, AU 45%  84%

14. No increase in the size of dark trades And in fact, a decrease in AU (due to lower block size threshold)

15. Decrease (increase) in dark (lit) same-broker trades (internalization) Internalization was a way of saving exchange fees and ‘cream- skimming’ uninformed order flow

16. No increase in lit liquidity provision (both) Lit limit orders to volume, lit depth to volume

17. Increase in spreads in both countries e.g., Quoted: CA ↑0.6 bps from 12 bps; AU ↑5.3 bps from 44 bps Robust to FE, control variables, and control market (diff-in-diff)

18. Why did spreads increase? Tale of intended and unintended consequences becomes A tale of two types …

19. Forced substitution was away from the ‘good stuff’, towards the ‘nasty stuff’ Midpoint: CA 33%  97%, AU 45%  84%

20. Plausible, But is that really what increased spreads? If it is, we would expect: 1.Stocks that experience more “substitution” (from two-sided to one-sided) should have a larger increase in spreads 2.The pre/post widening of spreads should be more pronounced for stocks that were tick size constrained

21. Test #1 of why spreads increased

22. Test #2 of why spreads increased Test: Partition stocks into two groups based on proportion of time they are tick constrained in the pre-regulation period Finding: tick constrained stocks have greater deterioration in spreads than unconstrained stocks – In Canada, only most tick-constrained stocks see spreads increase

23. Conclusions Intended consequences: – Significantly reduced dark trading – Dark trades give much more price improvement (almost all dark is at the mid) – Less dark internalization Unintended consequences – No increase in dark trade sizes – No increase in lit liquidity provision – Wider spreads Reason? – Forced substitution from beneficial two-sided to harmful one-sided dark trading Suggestions? – Move to a finer pricing grid if we have minimum price improvement