Dark Trading

Shedding Light on US and EU Regulation of the Securities Markets' Dark Sector

Anna-Carina Salger

• Publisher: De Gruyter
• Year: 2020
• Print ISBN: 9783110661446
• eBook ISBN: 9783110662092
• Edition: 1
• Topic: Law
• Subtopic: Management
• Index: Law

This book explores the pressing topic of dark trading. Following new EU legislation regulating financial markets (MiFID II and MiFIR), it traces the development of off-market securities trading ("dark trading"), analyzes economic studies of this development, and positions the resulting regulatory framework of the EU over against that of the US. The study closes with proposals for reform that provide new impetus for further scientific discussion.

Chapter 1 Rise of Dark Trading and its Classification Within the Market Structure

Over the past decade, technological developments, regulatory changes, and increasing globalization led to significant structural changes in the securities markets and the trading industry worldwide.¹ On the one hand, technologies enabling high-frequency trading offered new possibilities to trade at speeds human beings cannot longer compete with. On the other hand, new regulations opening the markets for off-exchange trading offered a way to escape from high-frequency traders and thereby caused an increase of competition and market fragmentation.² Consequently, the overall liquidity has become increasingly fragmented over these multiple trading venues accompanied by a general shift of trading volume away from the public exchanges towards off-exchange trading venues.³

The traditional public exchanges are generally transparent, because the orders they match are usually visible to the market participants and executed transactions are posted to the public immediately, and thus are also referred to as ‘lit venues’.⁴ In contrast, off-exchange trading venues, allocated to the over-the-counter (OTC) sector, do not have the same transparency requirements, and thus are mainly non-displayed, a characteristic that is described as ‘dark’ contrary to ‘lit’.⁵

This chapter first provides a definition of the term ‘dark trading’ and explains in further detail the different categories and its classification within the market structure (A.). Second, it points out the major historical developments and, in particular, its relation to high-frequency trading (B.), which are necessary to understand why dark trading plays an important role in today’s securities markets and why it is gaining increasing attention. The third part (C.) sums up the main conclusions.

A. Definition and Classification of Dark Trading

Dark trading sounds very ominous and, in contrast to lit trading, naturally tends to have a negative connotation. The term ‘dark’ is often used to describe unregulated areas with the potential to facilitate criminal activity because they are difficult to supervise.⁶ Although dark trading is proven to provide some benefits to the markets, so it is not harmful per se, there is some truth to its negative reputation as well.

The following part defines the term ‘dark trading’ (I.), assesses what makes trading dark in contrast to lit trading (II.), and sets forth the different categories and types of dark trading (III.). Today, dark trading appears in every securities market, more or less in all its variations. However, the international legal systems differ in regard to the classification and the legal terminology. For concreteness, the following explanations are tailored to the legal terms used in the regulatory framework of the United States (US).⁷ References to the equivalents in other legal systems, particularly the system of the European Union (EU), are made if necessary. The details of the differences in the venue classification are discussed in Chapter 3 within the context of each regulatory framework.

I. Definition of Dark Trading

Dark trading is a rather visualized description of trading whereby trades are being executed without revealing information, for example, about submitted orders, prices and the investors participating, at least prior to the execution of a trade.⁸ It usually occurs in the form of off-exchange trading on dark venues or in the form of hidden orders on otherwise lit venues.⁹

Although dark trading just recently gained remarkable attention, it is not an entirely new phenomenon but has long existed in form of upstairs trading, where brokers, instead of routing an incoming order to an exchange for execution, filled the order, for instance, with the firm’s own inventory.¹⁰ Traders have always sought ways to preserve anonymity and execute orders with minimal market impact.¹¹ However, the variety of types of dark trading has increased rapidly, causing a rise in the amount of dark trading in the securities markets and attracting much more attention to this practice.

II. Dark Trading vs. Lit Trading

In order to understand what makes trading ‘dark’, it is important to take a closer look at its key characteristics and its counterpart, ‘lit trading’. Put in simple terms, trading requires the execution of two matching orders, an order to sell and an order to buy. Therefore, the participants first need a market¹² and a market place, i. e. a trading venue, where they can meet and submit their orders. There are several kinds of trading venues participants can choose from.¹³ Second, the participants need information about available trading opportunities to find out who they can trade with and to determine the price reflecting the value of the respective security. If all this information is revealed to the public the market place is considered to be ‘lit’.

1. Key Characteristics

Deriving from the general explanation above, the key characteristics of lit trading can be summarized as transparency and price discovery. Basically, a trading venue is lit if the liquidity available, i. e. its orders and quotes, is openly displayed and thus transparent to the general public, particularly before trades are executed, and dark if it is not.¹⁴ While in a lit venue the participants can observe the orders submitted by other participants, in dark venues, all orders are hidden.¹⁵ Since the liquidity is not displayed in a dark venue, market participants cannot immediately find out whether there are other orders available matching their orders.

In order to achieve transparency, lit venues are required to publish not only post-trade but also pre-trade order information.¹⁶ When an investor places an order to buy or sell on a ‘lit’ venue in the US registered with the SEC, the venue makes this quote available to the public by sending it to the ‘consolidated tape’, a high-speed, electronic system which publicly displays current prices and real-time volume data on sales of exchange-traded securities.¹⁷ The Consolidated Tape Association oversees the Consolidated Tape System and the Consolidated Quotation System which provide data streams about real-time trade and quote information.¹⁸ Using the data sent to the systems, the Security Information Processor (SIP), registered with the SEC under Section 11 A of the Securities Exchange Act of 1934 (SEA)¹⁹, calculates the national best bid and offer (NBBO) for securities and presents it to the public on the screens.

In the EU, unlike in the US, there is no publicly available standardized and consolidated detailed trading information for all venues.²⁰ Rather, the European lit venues individually provide their own data feeds and make their trade and quote information available separately.²¹ However, the European regulator has taken measures to harmonize the transparency requirements when implementing the first Markets in Financial Instruments Directive (MiFID I)²². Accordingly, the provisions under MiFID I required the Member States to implement rules to ensure that regulated markets publish current bid and offer prices and the depth of trading interests, summarized as pre-trade transparency requirements, and to publish price, volume and time of the transactions as close to real-time as possible, contributing to post-trade transparency.²³ Under the new regime comprised of a second Directive on Markets in Financial Instruments (MiFID II)²⁴ and the accompanying Markets in Financial Instruments Regulation (MiFIR)²⁵, both adopted in 2014, the EU regulator also introduced rules governing how consolidation is to be done.²⁶ However, in contrast to the US, there is no monopoly provider but several ‘consolidated tape providers’ competing to consolidate data. Moreover, the regulatory regime applies only to post-trade data.²⁷

The other key characteristic of lit venues is that they provide and facilitate price discovery.²⁸ While lit venues determine the prices at which trades are executed according to the trading interests, i. e. supply and demand, as reflected in the amount of incoming orders²⁹, dark venues often adopt these prices and use them as a reference.³⁰ Thus, dark trading may cause littl...

Table of contents

• Title Page
• Copyright
• Contents
• Acknowledgements
• Acronyms and Abbreviations
• Introduction
• Chapter 1 Rise of Dark Trading and its Classification Within the Market Structure
• Chapter 2 The Impact of Dark Trading on The Market
• Chapter 3 Regulatory Approaches of Different Legal Systems
• Chapter 4 Final Comparison and Recommendations
• Summary of the Final Conclusions
• Appendix – Literature Review
• Bibliography
• Index