Fifty-shades of grey: Competition between dark and lit pools in stock exchanges
Introduction
By providing companies with access to the capital, equity markets are vital components of economic growth. Since the early 2000’s, there has been a growing consensus amongst regulators that an effective transparency regime1 is able to deliver the full benefits provided by the coexistence of different market microstructures. Therefore, at the same time in 2007, two regulatory projects came into force on both sides of the Atlantic: Reg NMS (Regulation National Market System) in the United States (US) and MiFID (Markets in Financial Instruments Directive – 2004/39/EC) in the European Union (EU). Both regulations had common objectives, such as enhancing competition between trading venues and fostering technological innovation. However, the regulatory paradigms and processes as well as the financial market history in both the US and EU have been substantially different. Although Reg NMS aims to modernize an already fragmented market (dealer markets), MiFID intends to break up the traditional centralized design defined by the monopoly of exchanges in trading services (order book markets).
With new legal frameworks, the controversy surrounding the proliferation of “dark pools” (hidden sources of liquidity) has been greater because both regulations contemplate the possibility to trade in the dark within the law. Historically, dark trading referred to upstairs markets and unregulated Over The Counter (OTC) facilities2 with restricted access and which were dedicated to block trades. The Regulation Alternative Trading Systems (ATS), introduced in 1998 by the US Securities and Exchange Commission (SEC), was the first attempt to regulate dark pools with a legal status. So, since then, dark pools in the US were already required to register as broker-dealers. Consequently, the shock of the regulatory transformations caused by the introduction of the MiFID was greater in Europe since such changes have included transparency waivers on public equity markets for the first time. Indeed, one of the main regulatory trade-offs in Europe was related to compliance with new pre-3 and post-trade4 transparency rules. The changes contained in the directive caused many new players to enter the European trading industry with differentiated business models to target new opportunities. The new landscape of the trading industry in Europe has not only moved from a consolidated structure to a fragmented one, but also out of the sunshine into more darkly shaded areas.
The expected positive effects for investors from the MiFID were a decline of transaction fees and an improvement of the diversification of trading services better adapted to varying investor needs. The ultimate goal was to enhance the attractiveness of the European securities marketplace, not only relative to its international competitors, but also to the unregulated OTC facilities. However, the European Commission (20105) noted that an increasing number of dark pools among new entrants was likely to be counterproductive and to affect the quality of the information about prices of securities traded on the regulated market. The fragmentation of order flow is also subject to controversy, sometimes accused of detering market liquidity and informational efficiency, while also praised for its positive effect on transaction costs and innovation. A possible explanation for those controversies is related to the fact that the financial markets are populated by economic agents with heterogeneous targets. What is beneficial for some could be detrimental to others. It therefore seems more appropriate to think in terms of the welfare of investors, trading services providers, and issuers.
Performing an analysis of the impact of dark pools on financial markets which accounts for welfare of those involved is the object of this paper. The two, main challenges are to: 1. delineate the relevant market and 2. include the main characteristics of financial market complexity, involving the following: industrial (platforms) and financial (issuers and investors) strategic behaviors, two-sided issues between platform users, and the existence of direct and crossed externalities. In this framework, how and under what conditions can a regulated dark fragmentation be beneficial to financial market participants? Microstructure theory helps to explain that price distortions on financial markets are, in part, the result of users’ (investors’) rational strategic behavior. However, to date, there has been little work on competition between lit and dark pools from an industrial organization approach. The existing work lacks a base from which to develop practical recommendations for regulators. As Cantillon and Yin (2011) argue, a microstructure toolkit is essential but not sufficient to understand the issues related to competition in trading services. Fragmentation is determined not only by the strategic behavior of investors but also by the strategies of trading platforms. Financial relationships between the supply (trading services providers) and the demand (investors) sides are affected by market externalities.
In the financial literature, very few models as Colliard and Foucault (2012), and Pagnotta and Philippon (2015), consider that supply and demand of trading facilities are endogenous. We herein model the interactive strategies of trading platforms and investors subject to the main conditions of the European regulations. By analyzing the spectrum of different market structures from the most consolidated (and thus, most lit) market to that which is both the most fragmented and most dark, we are able to capture the impact on market externalities and the global welfare. We show that lit-only fragmentation is less desirable than consolidation. However, the authorization of very limited dark trading is the worst solution by far. If the regulation includes transparency waivers, they must be sufficiently non-restrictive to be efficient against competition from OTC facilities.
The paper is organized as follows. Section 2 discusses the financial market fragmentation puzzle within the academic literature. Section 3 describes the European regulations and the context of our modeling. Section 4 presents a benchmark model (a consolidated exchange in competition with OTC facilities) which reveals the determinants of the distribution of heterogeneous investors among trading possibilities. A fragmented market structure with alternative lit pools (i.e. compliant with pre- and post-trade transparency rules) is analyzed in Section 5. Section 6 analyzes a fragmented market structure with alternative lit and dark pools. At each stage, we analyze the effect of competition on trading fees and volume effects, and finally, on welfare. Numerical simulations are presented in Section 7, and the main results are set within a policy perspective based on the European context.
Section snippets
Literature
According to the literature, financial markets perform two functions: they determine the equilibrium price of assets, and they facilitate the matching of issuers and investors (Bencivenga, Smith, 1991, Levine, 1991). These functions require a price discovery process observable by all market participants, and a sufficient number of counterparties to facilitate the matching process. However, neither the literature nor the empirical evidence define what is the best market structure.
Consolidation
Settings
At an operational level, stock exchanges are two-sided markets that serve two types of customers, namely listed firms and investors who trade stocks. As the advent of electronic processes has eliminated the need to have a physical place, exchanges are currently much more than a geographical location. However, the terminology used to name the players and the scope of markets varies depending on the stakeholder’s perspective. As a result, the terminology used to describe market infrastructure
The benchmark model
The benchmark model provides a simplified representation of a consolidated exchange. Trading services are provided by an incumbent, in a position of monopoly. The incumbent’s earnings are the sum of a listing profit based on the listing fees paid by issuers, and a trading profit based on the fees paid by investors. We consider a simple-homing setting where investors use either exchange or OTC facilities. OTC trades do not contribute to the public price discovery process of the exchange.
There
Lit pools
In this section, we consider the entry of lit pools, competing with the incumbent on the transparent segment. Lit pools, like the incumbent, offer pre- and post-trade transparency. They can offer differentiated trading services with different matching rules (call auction vs. continuous auction), different kinds of orders (limit, market, fill or kill, stop, open, iceberg...), and different technologies (immediacy, connectivity, accessibility...).
The superscript L denotes lit pools
Dark pools
This section studies the entry of dark pools. Dark pools offer pre-trade opacity. The overall price discovery process is fed by pre- and post-trade transparency (Levin, 2003). The contribution of dark pools to this process then is lower than the contribution of both lit pools and the incumbent. Here the superscript T denotes transparent platforms (incumbent and lit pools), while D denotes dark pools and O the OTC facilities.
There are k′ dark pools. Investors joining these opaque platforms
Simulations
To illustrate Propositions 3 and 4, in this section, we now turn to numerical simulations of the theoretical setting presented in Sections 4 through 6. With different numerical values for the parameters of the model, we assumed the incumbent to be a monopolist in intermediation functions or having various competitors in trading activities. In the most complex case, when both lit and dark pools compete with the incumbent, we selected different levels of dark pool opacity and examined the
Concluding remarks
The current regulatory trend in financial markets is toward fostering on-exchange competition between trading service providers and extending the possibility of dark trading through pre-trade transparency waivers. Under the MiFID (2004/39/EC), European markets have become fragmented between lit and dark trading pools. Both the fragmentation and the rising opacity within the regulated markets are controversial. Most academic studies and governmental reports have drawn mixed conclusions about
Acknowledgments
We thank Co-Editor-in-Chief Christiaan Hogerdorn, Associate Editor Pai-Ling Yin and two anonymous referees for their careful reading of our manuscript and their many insightful comments and suggestions. We also acknowledge P. Adämmer, P. Bougette, B. Buchanan, A. Direr, A. Gautier, T. Gehrig, Y. Jégourel, D. Lahet, H-M. Trautwein and A.G. Vaubourg for fruitful comments and discussion. Editing support from R. Todres is kindly appreciated. All remaining errors are ours.
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