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Aggregated Market Quality Implications of Dark Trading

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Aggregated Market Quality Implications of Dark Trading Aggregated Market Quality Implications of Dark Trading GBENGA IBIKUNLE* University of Edinburgh, United Kingdom European Capital Markets Cooperative Research Centre, Pescara, Italy Centre for Responsible Banking & Finance, University of St Andrews, United Kingdom1 MATTEO AQUILINA Financial Conduct Authority YUXIN SUN University of Edinburgh, United Kingdom IVAN DIAZ-RAINEY University of Otago, New Zealand Abstract We test predictions regarding the implications of operating dark pools alongside lit venues for market quality in London ‘City’ venues. We find that dark trading at moderate levels enhances market transparency, and reduces both trading noise and incidences of potential trading manipulation. Results, however, imply that there is a threshold of value when dark trading diminishes transparency, and thus induces deterioration in market quality. We estimate this threshold to be about 15% of the aggregate market trading value. We also observe variations across stocks based on stock liquidity, with 5% and 18% for the highest and lowest liquidity stocks respectively. JEL classification: G10, G14, G15 Keywords: Dark pools, MiFID, Multilateral Trading Facilities (MTFs), Market Transparency, Adverse Selection, Probability of an Informed Trade (PIN), Trading noise *Corresponding author: University of Edinburgh Business School, 29 Buccleuch Place, Edinburgh EH8 9JS, United Kingdom; e-mail: [email protected]; phone: +441316515186. We thank seminar participants at the 19th November Seminar at the University of Reading’s ICMA Centre, Alfonso Dufour, Albert J. Menkveld and Marius Zoican for helpful comments and discussions. Ibikunle acknowledges funding from the University of Edinburgh’s First Grant Venture Fund and data support from the Capital Markets Cooperative Research Centre, Sydney. 1. Introduction Over the course of the last decade regulators have stepped up efforts to make global financial markets more transparent and fairer, especially in the US and the EU. The regulations enacted, the Regulation NMS (RegNMS) in the US and the Markets in Financial Instruments Directive (MiFID) in the EU, coupled with technological advancements, have in effect led to the proliferation of new classes of trading venues. One of the most prominent new venue type is a class of opaque venues known as ‘Dark Pools’. Trades executed on dark pools have no pre-trade transparency, i.e. market participants, other than the submitter and the pool operator, are not aware of the presence of orders submitted to a dark pool prior to their execution. Dark pools in Europe are mainly operated as Multilateral Trading Facilities (MTFs); the three largest dark trading venues on the continent are MTFs, which operate both dark and lit order books. These are Chi-X Europe, BATS Europe and Turquoise, all are based in London, United Kingdom. Considering that a non-negligible proportion of European exchange volumes are now executed in the dark,1 it is vital to investigate how these volumes impact overall market quality in the City. Such an investigation is also of critical importance for investors who already view dark pool activity with some suspicion (see Schacht et al., 2009). The scepticism appears valid; a lack of pre-trade transparency suggests that dark pools reduce market transparency, thus going against one of the aims of the new market regulations enacted over the last decade. However, recent studies offer differing a view (see Zhu, 2014; Comerton-Forde and Putniņš, 2015). This paper contributes to the dark pools debate by presenting the first evidence on the impact of dark trading on aggregated market quality; the study is based on the largest EU equity market, the UK equity market. In a recent dark pools review by the Financial Conduct 1 For example, on an average day in October 2016, approximately €1.3 billion worth of dark transactions were executed on Chi-X’s BATS Europe (BXE) and Chi-X Europe (CXE) dark order books. This figure is based on daily updated data released on BATS Trading website in October 2016. 2 Authority (FCA), it was noted that “the UK equity market and regulation differs significantly from the US and other markets, including with regard to dark pools”,2 hence a comprehensive investigation of the impact of dark trading within the UK regulatory environment is called for. In carrying out this investigation, this study uses high frequency data for 282 of the largest stocks from the London equity market. The stocks used are constituents of the FTSE 350; thus, the data effectively covers the entire London market over a recent five-year period. In this paper we test the theoretical proposition that the addition of a dark trading venue to a lit trading venue improves overall/aggregate market transparency and quality. Results obtained suggest that it does in the London market once trading in all the major venues is aggregated. Specifically, when the major equity trading venues in London are consolidated into a single order book, the current levels of dark trading in the market over the five-year period between June 2010 and June 2015 enhances market transparency and reduces trading noise in the London equity market.3 Our findings have significant implications for the regulation of European markets given the potential welfare impacts of dark pools in terms of how market quality influences firm production decisions and asset allocation. This potential for impact beyond the financial markets makes it vital that we fully understand the impact of dark pools on market quality characteristics. Increased understanding of the role of dark pools is also critical for adequately crafting policies aimed at ensuring that their benefits are enhanced, while potential pitfalls, if any, are guarded against. However, the study/knowledge base needed for constructing a full picture of the market microstructure impacts of dark pools is still very much in formation at this time. There are several reasons behind the dearth of empirical 2 See the FCA Thematic Review TR16/5: UK equity market dark pools – Role, promotion and oversight in wholesale markets, published in July 2016 and available at: http://www.fca.org.uk/static/documents/thematic- reviews/tr16-05.pdf 3 Often distinctions are made among types of dark trading approaches (see for example, Foley and Putniņš, 2016). In this paper, our data and market structure information available from the examined exchanges indicate that we exclusively deal with ‘midpoint dark trading’ data. 3 academic literature on the dark pool phenomenon. Firstly, modern dark pools are still comparatively new trading venues, hence the relatively small number of studies either published or in development. Secondly, it is difficult to obtain datasets which explicitly identify trades executed via dark pools. The latter of these two issues is being rapidly resolved, as new datasets identifying dark trading activity are now emerging. This study benefits from one of such data sources. Transparency, which should be enhanced by publicly displayed trading, is a vital ingredient in well-functioning financial markets, and aids efficient price discovery. Therefore, it implies that venues with no pre-trade transparency, like dark pools, are potentially harmful to financial markets’ trading quality, and they might even have welfare consequences for the economy and society (see also Zhu, 2014). According to the March 2014 edition of the Thomson Reuters Equity Market Share Reporter, dark pool activity for all European equities accounted for more than €80.23 billion in March 2014, which was about 8.50% of all traded equities on the continent that month. For the 12-month period ending March 2014, the total value of dark trades stood at more than €898.22 billion, which represented more than 9.55% of all equity trades in Europe during that period. These are economically significant values; therefore it is unsurprising that there has been a lot of apprehension among market participants that dark pools could negatively impact trading quality. A survey conducted among market participants by the CFA Institute finds that 71% of respondents are of the view that dark pools constitute problems for price discovery in the markets (see Schacht et al., 2009). Despite the concerns evident within the practitioner industry, academic theory suggests that the issue is a much more complicated one, and that dark pools could actually be beneficial to financial markets trading. One of the main theoretical contributors to this emerging debate, Zhu (2014), holds that under natural conditions, uninformed traders 4 gravitate towards dark pools, while informed traders largely trade on the lit markets. This manner of self-selection should result in the reduction of trading noise normally induced by noise/uninformed traders when they submit their orders to lit markets, and therefore improve overall market price discovery. However, Ye (2011), employing a different framework of informed and uninformed traders, disagrees with Zhu’s (2014) predictions. The difference in model predictions could be linked to differences in modelling approaches. While Zhu (2014) assumes that both informed and uninformed traders can freely select their trading venues, Ye’s (2011) theoretical model gives only informed traders this selection ability.4 Over the past few years, several empirical working papers examining different aspects of dark pool trading activity have been developed. For example, Buti et al. (2011), Preece and Rosov (2014), Ready (2014) and Brugler (2015) investigate liquidity issues with regards to dark pools. Others, such as Comerton-Forde and Putniņš (2015), Foley and Putniņš (2016) and Aquilina et al. (2016), examine price discovery-related functions of the market. It is important to note that the variations in the regulatory environments, nature of data, and dates covered make these papers distinct. Most of this literature uses US data, and where there is UK data used it is limited, as are the time periods covered. This paper is the first large sample study of the impact of dark pools on market quality in the UK and under the MiFID regulatory environment.
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