Dark pools are a complex topic subject to misunderstanding amongst the broad public, media, and government regulators. To help provide a better perspective, we discuss the evolution of equity markets that led to the development of electronic trading, dark pools, and current market structure. We move on to analyze dark pools and their overall impact on trading. We then discuss further aspects of dark pools in particular, and consider regulation and global trends in market structure.
Historical Perspective on Equity Markets
The first modern equity market was established in the Netherlands in 1610 with the publically traded shares of the Dutch East India Company. Financial transactions had taken place since the dawn of civilization, but 1610 was a milestone towards the development of the equity markets we know today. Because equity securities represent transferable ownership interests in corporations, dividing business organizations into small, affordable pieces made it easier for entrepreneurs to raise capital from multiple sources. At the same time, limited liability allowed investors to diversify their investments without fear of incurring risk of personal accountability. Enhanced liquidity also eased transfer of ownership. Secondary markets for the securities of public firms quickly developed as the number of companies increased. Merchants and traders bought and sold securities just like other commodities, and specialization soon flourished. Stock exchanges were developed to enhance liquidity, transaction settlement, and protect broker commissions. The New York Stock Exchange(NYSE) originated out of the famous Buttonwood Agreement of 1792, in which a group of 24 brokers agreed to exclusively trade amongst themselves and fix commissions at a minimum of 0.25%; this system of fixed commissions lasted until 1975. Technology has always played a prominent role in driving the evolution of financial markets. The invention of the telegraph and stock ticker, for example, in the nineteenth century made it possible to transmit price and order information quickly and over large distances. Indeed, it was the skillful use of the stock ticker to efficiently disseminate pricing information that led the NYSE to become the dominant stock exchange in the United States. Years later, the rise of computer technology would fundamentally change the economics and future development of markets. The 1970s witnessed the creation of NASDAQ (National Association of Securities Dealers Automated Quotation) and Instinet, an electronic quotation system. Traditionally, non-exchange listed stocks (OTC securities) required brokers to request prices and trade over the phone. NASDAQ and Instinet allowed brokers and dealers to electronically publish quotes (bid/ask prices) on a consolidated display, which encouraged information efficiency, reduced spreads and improved liquidity. NASDAQ and Instinet gradually established a network effect to attain a critical mass of brokers and built the necessary operational and regulatory infrastructure to become formal electronic stock exchanges. A major scandal erupted in 1994, when NASDAQ dealers (e.g. market makers) were accused of colluding to maintain wide bid/ask spreads, which reduced risk and helped ensure high profits. The US Securities and Exchange Commission (SEC) responded in 1996 by imposing order handling rules that required brokers and dealers to publish customer limit orders in their quotes (which were previously hidden at their discretion) and execute client orders at the best published price. Further regulatory and political pressure on exchanges and Wall Street decreased the minimum quote variation (i.e. the minimum price interval between bid/ask) from 1/8th of a dollar ($0.125) to 1/16th ($0.0625) in 1997, and to decimalization ($0.01) in 2001 to encourage competition. Finally, in 2005, the SEC established Regulation National Market System (Reg NMS) which required exchanges to honor the...
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