The following post comes to us from Ronald Masulis, Scientia Professor of Finance at the Australian School of Business. It is based on his recent paper, Trading Rules, Competition for Order Flow and Market Fragmentation, which is co-authored by Amy Kwan, Lecturer at the University of Sydney, and Thomas McInish, Holder of the Chair Excellence at the Fogelman College of Business and Economics at the University of Memphis. The paper is forthcoming in the Journal of Financial Economics and is available here.

In the U.S.’s highly fragmented markets, approximately a dozen exchanges (e.g., NYSE, NASDAQ, AMEX, and BATS) compete with more than 40 dark pools (typically electronic trading platforms such as Credit Suisse’s Crossfinder and Goldman Sachs’ Sigma X) for trades in the same security. By early 2014, more than a third of all U.S. stock trading volume takes place on dark trading venues. This reflects the rapid growth in importance of off-exchange trading systems for U.S. equity trades following adoption of Regulation National Market System (Reg NMS) in 2005. Much of this growth is concentrated in ‘dark pools’, which doubled in market share from about 7% in early 2008 to an average of 14.54% in 2013. What is causing the growth in dark pools, which are alternative trading systems that operate much like traditional exchanges with the additional benefit of pre-trade opacity? One concern is that dark pools may have achieved this rapid growth in part from more favourable regulatory treatment.

In our new Article, Trading Rules, Competition for Order Flow and Market Fragmentation, forthcoming in the Journal of Financial Economics, we show that differential market regulation concerning minimum bid-ask spreads and price increments has given dark pools an important economic advantage, leading to more dark pool trading at the expense of traditional exchanges. One clear result is increased market fragmentation of the U.S. stock markets.

On the exchange, a transaction takes place when buy orders match sell orders at the best price. Often, there will be more than one order placed at this price, so exchanges prioritise orders that arrive first. When quotes on the exchanges are constrained because there is only a one penny difference between the price at which traders are willing to buy and the price at which they are willing to sell, additional trading interest is reflected in a build-up of depth, or trading queues, in the exchange’s order book.

Under the current regulatory framework, limit orders submitted to dark electronic communication networks (DARK-ECNs) can execute ahead of displayed orders on transparent exchanges as long as the price is at or within the National Best Bid and Offer prices. This means that some limit order traders can effectively queue jump limit orders displayed on the lit exchanges by submitting their orders to a DARK-ECN.

We use a discontinuity at the $1.00 price level to examine the effects of the minimum pricing increment on intermarket competition. Rule 612 prohibits displaying, ranking, or accepting orders priced at more than two decimal places for stocks priced at or above $1.00 by broker-dealers and exchanges. When stock prices fall below $1.00, the required minimum pricing increment for exchange trades drops from a penny, or $0.01, to $0.0001. Thus, there are strong incentives for traders to migrate their order flow to dark venues to benefit from queue jumping when the stock is trading just above a dollar, which is immediately lost when the stock price falls below a dollar.

Studying trading volume in the competing venues, we find a discontinuity in the DARK-ECNs’ market share of trades as the stock price rises just above $1.00; DARK-ECNs’ market share of trades in stocks priced just above $1.00 is almost double that of stocks priced just below $1.00, which is robust to various measures of market share. The abrupt rise in DARK-ECN market share is also mirrored by an abrupt fall in the market share of trades of traditional exchanges. Just the reverse occurs when stock prices fall below a dollar.  These findings are statistically significant and are based on regression discontinuity design analysis. This evidence indicates that the SEC’s Minimum Pricing Increment Rule gives DARK-ECNs a competitive advantage that has persisted over time and provides one explanation for the rapid rise in dark pool market share.

The effects of the minimum pricing increment on intermarket competition are not limited to penny stocks. Minimum pricing increments also cause large buildups of liquidity demand for higher priced stocks constrained by tick size. For example, a low-priced stock constrained by the penny tick size is likely to have longer order queues compared with a high priced stock that is also trading at a penny bid-ask spread since spread is positively related to stock price.

We estimate a predicted bid-ask spread model for each stock in the absence of a minimum pricing increment using factors documented in the market microstructure literature to affect spreads. The strength of the spread constraint in a stock is measured by the observed bid-ask spread minus its predicted value. Consistent with the previous evidence on queue-jumping, we find that the market share of dark pools increases with the strength of the spread constraint. Additionally, on trading days when stocks are severely constrained by the minimum pricing increment, DARK-ECNs experience gains in market share.

In another experiment, we examine the effects of the minimum pricing increment using a sample of stock splits and reverse stock splits. Stock splits and reverse stock splits provide an ideal setting to examine intermarket competition as they are often accompanied by large increases and decreases in the stock price and liquidity. Consistent with the queue jumping hypothesis, we find a decrease in dark venue market share for reverse stock splits that reduce the strength of the spread constraint and an increase in dark venue market share for forward splits that increase the strength of the spread constraint.

One implication of our body of evidence is that price discovery appears to be taking place in non-transparent dark pools because bid-ask spreads on traditional exchanges are regulated by a minimum tick-size constraint. Over time, the ability to queue jump on some dark venues can discourage traders from providing liquidity to traditional lit order books, resulting in wider spreads and less depth.