Do Black Swans Swim in Dark Pools?

First Published in Automated Trader Magazine Issue 09 Q2 2008

The continued rise of dark liquidity and the development of more sophisticated execution algorithms could increase regulatory obligations on brokers and/or exchanges, according to Mary Lou Von Kaenel, Managing Director, Management Consulting, Jordan & Jordan, and Greg Malatestinic, Senior Software Engineer, Jordan & Jordan.

In the wake of regulatory changes aimed at price transparency and best execution, and as market participants wade through their post-Reg NMS and MiFID implementation issues, many wonder: where has all the liquidity gone?

Securities regulation in the United States and Europe has placed a spotlight on trade price reporting and quotes, and has set the stage for competition among exchanges, multilateral trading facilities and electronic communication networks. Focused on ensuring that investors receive the benefit of fair and competitive markets, the US Securities and Exchange Commission (SEC) and the Committee of European Securities Regulators have reduced barriers to entry in support of off-exchange trading with the introduction of Reg NMS and MiFID respectively, to accomplish their objectives.

The rule makers have taken different tacks to hit their marks. MiFID is principles-based, placing the onus on market participants and their clients to agree on practices and procedures for trade execution that consider not only price but speed and likelihood of execution, as well as other costs related to execution and settlement. However, the SEC has charted a more direct, rules-based course for orders and trades, insisting under the Order Protection Rule (Rule 611 of Reg NMS) that the top-of-book displayed quote in each protected market must be hit before a transaction can be executed at an inferior price.

The SEC also requires all trades and quotes to be reported on a conso...

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