The risk and reward of darker trading

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Dark pools, less regulated trading venues in the United States, are becoming increasingly popular. Advocates of these trading platforms claim they boost market liquidity while reducing risk, while critics say their lack of transparency exposes them to predatory practices. Despite their controversy, dark pools have taken the United States by storm, capturing over 40% of the average daily market share and reaching up to 50% on certain days in the United States, while in countries like the Canada, they represent only 7% largely due to a higher level of regulation. Nasdaq Canada CEO Dan Kessous and Rosenblatt Securities partner Justin Schack weighed in on the stark differences in market participation and use of dark pools in the United States and Canada. In a recent TradeTalks segment, they discussed how dark pools work, the benefits and concerns of these sites in the marketplace, and how governments will regulate them in the future.

The main reason for using dark pools

When institutional investors need to trade large amounts of stocks, these orders tend to have a big impact on the market. For example, if a company sells 1 million shares of a security, trading those shares on a public stock exchange can cause the share price to drop significantly, creating more volatility in the market and a lower price. lower execution for the investor.

The problem of price volatility that can result from trading institutionally sized orders was accentuated when trading went electronic. Faster trading means faster changes in the market. Today, market price changes occur in milliseconds.

However, if a company can find buyers, sell its shares in bulk privately, and later disclose those sales to the public, market prices will have less of an impact on prices, ultimately reducing risk and dragging the investor down. for sale at a higher price.

According to Schack, “You have a very large order which can sometimes move the market. Entering the dark market can minimize that footprint, keep you anonymous, and result in better quality of execution. Then the market makers on the other side of those retail orders take less risk. It is less risky for them than putting a quote on a stock market. So, you can often get better results, and that’s why we see many types of market participants using these dark markets.

The pros and cons

Many supporters of dark pools including purchasing institutions such as mutual funds and pension funds champion the cost advantages of these trading platforms – by facilitating better execution prices, retirement accounts can continue to grow. accumulate value, which is then directly translated for the retail investor with a 401k pension, or other retirement account.

But dark pools are not universally supported by all market players. Critics complain that their lack of transparency is worrisome and is made worse by the fact that they are less and less used for their original purpose, which minimizes the impact on the market when negotiating large orders. . Celent, a financial technology consultancy, found that between 2009 and 2013, the average size of executions traded on dark pools in the United States fell by more than half, from 430 to 200.

Dark Pools: pros and cons

Benefits of dark pools Disadvantages of Dark Pools
Reduce the impact on the market Lack of transparency
Increase off-exchange liquidity Potential conflicts of interest
Minimize price devaluation Preferred trading prices
Minimize information leaks Customer segmentation
Control costs Market fragmentation

“Now there’s this huge conversation about, is there too much dark trading? Are there any conflicts of interest involved in some of the ways retail orders are executed? And I think the SEC has said it is working on rules it expects to come up with by April. It can make some pretty big changes to a lot of these things. So who knows? Schack said.

Outlook for dark pools

As U.S. investors wait patiently for possible SEC regulation and whether the SEC will reconsider its views on allowing stock exchanges to operate dark pools, in Canada Kessous hopes to increase the use of dark pools in the years to come. future. Nasdaq Canada’s CXD Trading Book, a dark pool created in Canada and launched in 2016, is now one of the best performing dark pools on the market.

“The two dark pools that get the bulk of the share are CXD and MatchNow. The other three together get about less than half a percent of the market share, ”according to Kessous.

By making retail orders free and inducing market makers to provide liquidity at improving price levels, Nasdaq Canada’s CXD has spurred trade and increased market share.

These innovations have made it possible to accelerate results.

“We hit the 1% mark a few years ago and have been growing since then. We are now catching around 1.6% per day and we have seen several days at around 2%, ”Kessous said.

Kessous believes that darker trading on the Canadian stock market will result in better returns for investors.

Conditional orders are another innovation of the dark pools that are developing in the markets. These orders allow traders to search for liquidity across multiple sites, entering orders ready to trade provided a matching counterparty is found. This creates potential for more trades and increases market liquidity, resulting in an overall increase in trades made.

” We saw [conditional orders] growing up in the United States, and it was well received and adopted by many attendees. It has increased market share and we have seen it in Europe as well. Now we see it in Canada; there are a few dark pools that put conditionalities on their books, ”Kessous said.

Going forward, Kessous is monitoring the effectiveness and efficiency of dark pools in the hope of providing more information on their impact on the market. “We did not rest on our laurels. We are looking at a model that will help find block liquidity and minimize the impact on the market. We will have that next year, ”Kessous said.

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