Introduction Existing Literature The Experiment Effect of Introduction Intra-Day Effects Interpretation

Dark Trading on the Toronto Stock Exchange

Sean Foley, Katya Malinova and Andreas Park

December 2, 2012

Introduction Existing Literature The Experiment Effect of Introduction Intra-Day Effects Interpretation

Motivation I

• The shift to dark trading has attracted the attention ofregulators and policy-makers worldwide.

• Concerns have centred on negative impacts for market quality.

• Proponents argue dark orders allow latent liquidity to beexpressed without large traders being “front run”.

• Opponents argue that dark trading removes liquidity from litmarkets and hampers the price discovery process.

Introduction Existing Literature The Experiment Effect of Introduction Intra-Day Effects Interpretation

Motivation II

• We study the introduction of dark orders on the TorontoStock Exchange in 2011.

• Results may also apply to dark venues introduced alongside litvenues that trade inside the spread.

• Studying Canada is instructive for the US due to the similarityof their markets and trade through prohibitions.

• Recent regulatory actions by the Ontario SecuritiesCommission and IIROC to curb dark trading make evidencecritical.

Introduction Existing Literature The Experiment Effect of Introduction Intra-Day Effects Interpretation

Emprical Issues.

1. The opaque nature of dark trading — one needs granular data.

2. It takes time for participants to begin using dark trading tools.

3. Potential endogeneity between dark trading and marketconditions makes causality difficult to identify (Buti et al.2011b).

4. The lack of immediate post-trade transparency in developedmarkets.

Introduction Existing Literature The Experiment Effect of Introduction Intra-Day Effects Interpretation

Empirical Solutions!

1. Order-level dataset for TSX trading, including information onall dark orders.

2. All TSX participants had immediate access to dark orders anddark and lit orders would interact.

3. We can address endogeneity:• Knowledge on dark order allows for the construction of a

suitable instrumental variable.• Introduction of dark order is exogenous → can use event-study

methodology and use event as an exogenous instrument.• Introduction occurred in two stages → can use

difference-in-differences.

4. Canada has immediate post-trade transparency for dark andlit trading.

Introduction Existing Literature The Experiment Effect of Introduction Intra-Day Effects Interpretation

Pros of Dark Trading I

• Buti and Rindi (2011; the results are in the WP, not in the2012 JFE version) develop a model and show theoreticallythat dark orders will increase depth.

• Bloomfield, O’Hara & Saar (2012): experimental evidencethat dark orders do not affect market outcomes (quotedspread goes up, but spreads including dark orders remainunaffected).

• Buti, Rindi and Werner (2011b) find that US dark pool usagehas beneficial impacts:

• Reducing spreads

• Increasing depth

• Reducing volatility

Introduction Existing Literature The Experiment Effect of Introduction Intra-Day Effects Interpretation

Cons of Dark Trading I

• A number of studies have found negative impacts of darktrading using various markets data as evidence.

• These negative impacts include:

• Increased Price Impact (Degryse, De Jong and Van Kervel2011, Weaver 2011, Nimalendran and Ray 2012,Comerton-Forde and Putnins 2012)

• Wider Quoted Spreads (Degryse, De Jong and Van Kervel2011, Weaver 2011, Nimalendran and Ray 2012,Comerton-Forde and Putnins 2012)

• Larger Effective Spreads (Degryse, De Jong and Van Kervel2011, Weaver 2011)

• Reduced Efficiency (Comerton-Forde and Putnins 2012)

Introduction Existing Literature The Experiment Effect of Introduction Intra-Day Effects Interpretation

Market Structure

• The TSX is the main exchange in Canada with more than60% market share in trading volume.

• There are 4 ATS’s (Chi-X, Alpha, Omega, Pure).

• There are 2 continuous dark pools:• Match Now (since January 2007)• Intraspread (since July 2011)

• Dark orders were introduced on the TSX in April and May2011 and can interact with dark and lit liquidity.

• Dark orders can be priced fully-hidden limit orders or floatingmid-point orders.

• Floating mid-point orders form over 65% of our sample ofdark trades.

Introduction Existing Literature The Experiment Effect of Introduction Intra-Day Effects Interpretation

Dark Order Introduction

• The TSX introduced dark orders on the 1st of April, 2011 forthe S&P/TSX-60 (and ETFs).

• On the 20th of May, 2011 dark orders were extended to allstocks.

• This staggered introduction provides a natural experimentalsetting in which to analyze the impact of the introduction ofdark orders.

• Unlike separate dark pools, the on-market nature of the darkorders means all brokers had immediate interaction with darkliquidity.

• Given full orderbook data we are able to analyse the impact ofcontinuous dark trading on a public exchange.

Introduction Existing Literature The Experiment Effect of Introduction Intra-Day Effects Interpretation

Data

• Data set is provided by the TMX Group.

• Covers all TSX listed stocks Jan-Dec 2011.

• Output of the trade matching engine includes all messages.

• Analyze the TSX-60 vs the TSX Completion (200)

• TSX Completion is the TSX-Composite minus the TSX-60.

• We focus on continuous market trading and thus excludedealer crosses.

Introduction Existing Literature The Experiment Effect of Introduction Intra-Day Effects Interpretation

02

46

810

% D

ark

Tra

ding

01jan2011 01apr2011 01jul2011 01oct2011 01jan2012January 15 − December 15, 2012

Total Dark Trading MA Total Dark Trading TSX Dark Trading MA TSX Dark Trading MatchNow MA MatchNow IntraSpread MA IntraSpread

Dark Trading TSX Composite

Introduction Existing Literature The Experiment Effect of Introduction Intra-Day Effects Interpretation

01

23

4%

dar

k

01jan2011 01mar2011 01may2011 01jul2011 01sep2011 01nov2011January 15 − November 15, 2012

TSX60 MA TSX60 TSX Completion MA TSX Completion

Dark TSX Trading TSX60 vs TSX Completion

Introduction Existing Literature The Experiment Effect of Introduction Intra-Day Effects Interpretation

Research Question: Does the introduction of dark orders

affect liquidity?

1. Estimate effect on TSX60, controlling for TSX Completion.

2. Possible caveats:• much happened in 2011 (but not so much in Q1 & Q2).• TSX60 are larger and more often cross-listed than TSX Compl.• TSX60 and TSX Compl. may react differently.• unobservable events

3. Variables of interest: quoted spread, effective spreads, depth,volume, fill-rates and volatility.

Introduction Existing Literature The Experiment Effect of Introduction Intra-Day Effects Interpretation

Regression Framework I

• Estimation 1: Effect of introduction event of dark orders onTSX60 relative to TSX Completion.

• Estimation 2: Effect of level of dark trading on TSX60relative to TSX Completion.

• Time horizon: January 01-May 20.

• Controls and models used:

• Mid-Quote• Market Fragmentation• Canadian VIX, also with differential effects of TSX60 vs. TSX

Completion• per-day and per-symbol fixed effects

Introduction Existing Literature The Experiment Effect of Introduction Intra-Day Effects Interpretation

Regression Framework II

• Estimated equation 1:

liquidity variablet = β0 + β1 × eventt ×TSX60i

+β2 × eventt + β3 ×TSX60i

+β4VIXt +

n

∑i=1

β4+icontrolit + ǫit.

• Estimated equation 2: 2-step regression of

liquidity variablet = β0 + β1 ×% dark tradingit

+β2 × eventt + β3 ×TSX60i

+β4VIXt +

n

∑i=1

β4+icontrolit + ǫit.

where % dark tradingit is instrumented by eventt ×TSX60i.

Introduction Existing Literature The Experiment Effect of Introduction Intra-Day Effects Interpretation

Regression Framework III

• All regressions control for stock fixed effects and standarderrors are double-clustered by firm and date.

• Result: the introduction of dark trading caused an increase inquoted spreads (as theoretically expected) and effectivespreads.

Introduction Existing Literature The Experiment Effect of Introduction Intra-Day Effects Interpretation

0.5

11.

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id−

ask

spre

ad in

cen

ts

01feb2011 01mar2011 01apr2011 01may2011 01jun2011 February 1 − May 31, 2011

Diff TSX60 − TSX Completion MA Diff TSX60 − TSX Completion

% TSX dark MA % TSX dark

Time−weighted quoted spread: TSX60 minus TSX Completion

Introduction Existing Literature The Experiment Effect of Introduction Intra-Day Effects Interpretation

Introduction Existing Literature The Experiment Effect of Introduction Intra-Day Effects Interpretation

Introduction Existing Literature The Experiment Effect of Introduction Intra-Day Effects Interpretation

Intra-Day Effect

• Idea: Throughout the day, what is the relation between darktrading and spreads/depth?

• Problem: Spreads/depth may also affect dark trading! (i.e.,trade dark only when depth is large and/or spread is small)

• Solution: find a variable (instrument) that is highly correlatedwith dark trading but that does not depend on spreads.

• Our approach: instrument %dark trading with %lagged darkorders.

• Time horizon: July 01-December 31

• Symbols: all TSX Composite symbols

• 10-minute intervals from 9:45 to 15:35.

• Result: dark trading reduces spreads (quoted and realized)and volatility and increases depth and volume.

Introduction Existing Literature The Experiment Effect of Introduction Intra-Day Effects Interpretation

Introduction Existing Literature The Experiment Effect of Introduction Intra-Day Effects Interpretation

Introduction Existing Literature The Experiment Effect of Introduction Intra-Day Effects Interpretation

Introduction Existing Literature The Experiment Effect of Introduction Intra-Day Effects Interpretation

Introduction Existing Literature The Experiment Effect of Introduction Intra-Day Effects Interpretation

Introduction Existing Literature The Experiment Effect of Introduction Intra-Day Effects Interpretation

Interpretation of the Results

• We find:• Introduction associated with an increase in spreads; no volume,

depth or volatility impacts.• Subsequent to introduction, on the intra-day level, dark

trading leads to tighter spreads, lower costs, more volume,more depth, and less volatility.

• Can these two be reconciled?• Yes. Theory predicts, that dark orders may lead to a widening

of the spread as traders avoid being picked off by larger-sizedorders that hit the dark first. ⇒ widening is predicted.

• Intra-day, dark trading is associated with no negative effectsbut instead creates “positive” impacts.

Introduction Existing Literature The Experiment Effect of Introduction Intra-Day Effects Interpretation

Some words of caution

• Results may understate the potential benefits of having theoption to trade dark.

• Dark orders have high fill rates, and execute at superior pricescompared to visible → benefit by switching from market todark midpoint orders.

• Without high frequency monitoring, one’s limit order maybecome stale – midpoint-pegged order do not.

• Marketable orders against dark orders have better price;effective spread accounts for it, but uptake of dark orders justafter the introduction may have been too low to reflect thisbenefit.

• Finally, in untabulated regressions: MatchNow had a similarlypositive intra-day impact on liquidity measures compared toTSX dark orders.