CSA/IIROC Position Paper on Dark Markets Released

Following on the heels of studies by the SEC, IOSCO, and the Australian Securities and Investments Commission, the Canadian Securities Administrators and the Investment Industry Regulatory Organization of Canada have released a joint position paper on dark liquidity in Canadian markets.

The paper lists those issues the regulator feeds need to be addressed immediately, and it contemplates amendments to National Instrument 21-101 and the Universal Market Integrity Rules.

The paper defines "dark order" as an order that is entered on a marketplace without being visible to other market participants, and "dark pool" as a marketplace with no pre-trade transparency for any orders. Partially undisclosed orders, such as iceberg orders, are not considered dark orders as they contribute to price discovery.

The main risks dark orders and dark pools pose to capital markets are making price discovery less efficient and reducing liquidity available to all market participants by diverting order flow that otherwise would have gone to visible, public markets. On the other hand, orders are dark because full disclosure of trading intentions may have an impact on the market price, leading to a worse fill. Dark pools offer an alternative to the upstairs market where institutional block orders were traditionally traded. Dark orders also offer potential liquidity to smaller orders that are sent to a dark pool first in search of a better price than that available on visible markets.

The paper sets out the regulators' positions on three issues:

1. Orders under a certain size should be required to be publicly displayed. The rationale for allowing dark orders not to be shown weakens if the order could be displayed with no market impact. Once entered, the order's size could not be reduced below the threshold (unless the reduction is due to a partial execution). The report suggests that the current threshold of 50 board lots in UMIR is an acceptable threshold, and invites specific feedback.
2. Two dark orders of at least the minimum size should be allowed to execute at or between the national best bid and offer (at or between (i) the highest price for a buy order on any market and (ii) the lowest price for a sell order on any market). All other trades involving a dark order should provide meaningful price improvement over the NBBO (at least a penny for all stocks trading over 50 cents, or a half-penny if the NBBO spread is one cent).
3. Within a market, visible orders at a price should have priority of execution over dark orders unless two dark orders exceeding the minimum size can execute. The regulators believe that this will enhance liquidity for larger orders, while requiring immediate post-trade dissemination of the trade details assists in price discovery.

The paper does not address other concerns. One is that the dark pool may try to attract order flow by offering a smart order router using data that is not available to other marketplace participants. This will be addressed in proposed amendments to NI 21-101 that are expected to be published in early 2011. The second issue is the practice of broker preferencing, which allows offsetting orders from the same firm to execute ahead of other orders at the price, even if those orders have established time priority. A request for information to allow the brokers to better evaluate the impact of preferencing will be published in the near future.

The deadline for comments is January 10, 2011.