Market Quality Is Best Served by Maintaining Strong Competition between Trading on Lit and Dark Venues, Says New Study

Media Contacts

Nicole Haroutunian
Director, Corporate Communications EMEA
+ 44 (0) 20-7330-9551

London , , United Kingdom, 19 November 2012

As larger volumes of equity-market transactions take place away from public exchanges, and concerns about transparency, investor access, and competition with traditional exchanges have been raised, a new study by CFA Institute concludes that markets best serve investors when there is strong competition between trading on lit and dark venues.

Dark Pools, Internalization, and Equity Market Quality, published today, examines the impact of undisplayed trading – which occurs in dark pools and via broker/dealer internalization – on market quality measures such as bid-offer spreads and market depth. The study shows that increases in dark trading are initially associated with improving market quality, but when a majority of trading in a stock occurs in undisplayed venues, market quality deteriorates (see methodology).

The study suggests that public policy measures should support fair competition and protect investors who display quotes in the public markets. The specific recommendations include:

  • Internalization of retail orders should be required to offer meaningful price improvement, thereby generating economically meaningful savings for retail investors and providing some protection to investors posting displayed orders on public exchanges.
  • Regulators should monitor the growth in dark trading and take appropriate measures if it grows excessively.
  • Dark trading facilities should voluntarily improve reporting and disclosures around their operations to enable investors and regulators to make more informed decisions over their use.

Rhodri Preece, CFA, director of Capital Markets Policy, CFA Institute, commented: “We believe that implementation of these considerations would help protect displayed orders while offering meaningful savings to retail investors executing away from public markets, maintain competition, and improve transparency. More fundamentally, these measures would enhance market integrity and lead to greater investor confidence in the equity market structure.

There were three primary motivations for the report:

  • With the volume of dark liquidity growing by nearly 50% over the past three years to account for nearly a third of consolidated volume in the United States, with a similar amount in Europe, there is a clear shift in the market structure away from trading on transparent exchanges and towards dark, or undisplayed venues. An example: The launch in August of the New York Stock Exchange’s Retail Liquidity Program (RLP), which is an undisplayed trading system for retail orders.
  • Regulators around the world have voiced concerns over dark trading, including those in the United States, Europe, Canada, and Australia, as well as the International Organization of Securities Commissions (IOSCO). The U.S. Securities and Exchange Commission (SEC) has considered regulatory proposals related to dark liquidity but has not passed any rules to date.
  • Members of the CFA Institute Capital Markets Policy Council have raised concerns that the incentive to display orders in public markets is undermined by certain off-exchange trading practices, such as sub-penny trading in which broker/dealers fill retail orders ahead of displayed limit orders by offering price improvement in fractions of a penny.

Notes to Editors


To conduct the study, a sample of 450 U.S. stocks stratified across listing market and market capitalization was selected by CFA Institute. For each stock, data on bid-offer spreads, top-of-book depth, off-exchange volumes, and other variables were obtained on a selection of dates over the period from the first quarter of 2009 through the second quarter of 2011.

Off-exchange trades reported to the FINRA/NASDAQ Trade Reporting Facility (TRF), which account for approximately 95% of all off-exchange trading, were sub-categorized into dark pools, internalization, or other OTC trading. Only aggregate off-exchange data is otherwise available; to the best of our knowledge, there are no other studies that look at disaggregated TRF data in this way.

To analyze the relationship between dark trading and market quality, bid-offer spreads and top-of-book depth were regressed on internalization and dark pool volumes and other explanatory variables. The results show that, after controlling for factors known to affect spreads and depth, increases in internalization and dark pool trading activity are initially associated with declining bid-offer spreads and increasing depth — that is, improving market quality. However, the relationship is not linear; beyond a certain threshold, it reverses. In other words, market quality initially improves but then declines as dark trading increases. We estimate that when a majority (>50%) of trading in a stock occurs in undisplayed venues, market quality deteriorates.

CFA Institute

CFA Institute is the global association of investment professionals that sets the standard for professional excellence and credentials. The organization is a champion for ethical behavior in investment markets and a respected source of knowledge in the global financial community. The end goal: to create an environment where investors’ interests come first, markets function at their best, and economies grow. CFA Institute has over 145,000 members in 163 countries and territories, including 140,000 CFA charterholders, and 148 member societies. For more information, visit