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Miranda Mizen

Formerly TABB Group

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Miranda Mizen

16 November 2012

A Spotlight in the Dark: An Inevitable Debate

 Executive Summary

It is clear from the hearings in Washington, SEC investigations, academic publications and water cooler conversations that at best, the US faces a severe image problem. In this research we continue our exploration of the issues and impact of market structure on the investor community and put the spotlight on one of the more contentious and inevitable debates around trading in the dark.

Currently, approximately 30% to 33% of all equity trading occurs off-exchange and is reported to one of the Trade Reporting Facilities. Dark trading occurs virtually indiscriminately across exchange-listed securities and some of the most liquid and highest capitalized securities have almost half their trading volume reported through the TRF. Buy-side traders with oversized orders to fill want sizeable fills, natural counterparties and the ability to avoid being seen, and the quality of the open markets makes the them willing partners in the dark.

The use of dark and undisplayed orders also on the exchange order books essentially makes the difference between dark execution on- and off the exchanges primarily one of regulatory framework rather than a debate over dark versus lit. In the aggregate, the details of the many exchange order types and rules that govern the markets create a tangle of detail, and in the highly fragmented market, this overwhelming detail adds to the complexity.

Many market participants believe the equity markets are now too fragmented and too opaque, and dark pools contribute to this. As dark execution comes under the microscope as part of the broader market structure debate, we believe the rules surrounding off-exchange trading in US equities will change — it is only a matter of time. But on- and off-exchange dark execution represents unique and valuable execution strategies, and there is danger in tarring all dark activity with the same brush. Any review must consider both environments. Any focus on dark trading needs to be grounded in data and measured against benchmarks of fairness and efficiency in the market to avoid being subject to speculation, polarized opinion and needle-moving regulation.

The TABB Group Vision Note A Spotlight in the Dark: An Inevitable  Debate puts the spotlight on one of the more contentious debates around trading in the dark and we inquire into dark execution on- and off-exchange and ask questions around the protected quote, criteria for off-exchange trading, and transparency. Trading outside the lit order books offers legitimate value and advantages but the industry lacks consensus about its cause and effect. Given current trends, action seems inevitable, but to be effective, the dark debate must be part of the broader market structure debate that includes the quality and efficiency of the lit markets.


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