The extreme volatility across financial markets over the past week overshadowed several interesting developments with respect to dark pools, which garner about 15% of all equity trading. One major US bank decided to close their dark pool, while another brokerage house announced new rules with respect to how orders are executed in anticipation of a change in regulations. The SEC confirmed they are investigating how orders are routed and payment systems, topics covered at the CFP conference held in September with FINRA. Please visit the CFP’s website to view the papers and presentations from that event.
Over the last few weeks this round-up highlighted several stories outlining the risks related the fixed income market’s structural shortcomings. The lack of liquidity and transparency in the fixed income market isn’t an issue created by the financial crisis, but it has been exacerbated by the regulations aimed at preventing another. The Dodd-Frank Act’s provisions regarding capital requirements and restrictions on prop trading effectively reduce a bank’s incentive to hold an inventory of bonds and by extension their market-making capabilities. The net result is a dramatic reduction in liquidity in the secondary market, which has even led to questions over the valuation of some rarely traded issues.
Professor Pete Kyle believes the fixed income market’s current structure is similar to the NASDAQ market in the 1980’s and early 1990’s, when almost all trades involved registered market makers on one side of the trade or the other. After the Department of Justice and the SEC forced changes in order handling rules in the late 1990s, non-broker-dealers were able to post limit orders and trade with one another, like they had been able to do for many years on the NYSE. Professor Kyle thinks that these change decreased bid-ask spreads on NASDAQ relative to the NYSE. There have been a number of attempts by fixed income market participants to create customer-friendly trading platforms. Professor Kyle thinks that now is the time for such platforms to gain permanent traction. Platforms which allow non-broker-dealers to supply liquidity to one another directly will allow market participants themselves to overcome some of the tendencies of the Dodd-Frank Act to reduce liquidity.
Wells Fargo to shut its ‘dark pool’ as demand falls
High-frequency trading firm fined for wave of last-minute trades
High-Frequency Trader Athena Capital Settles Stock-Manipulation Charges
Dark Pools Face More Enforcement Actions, SEC Lawyer Says
Volckerized Wall Street Dumping Bonds With Rest of Herd
Fund Traders Dig Deep for Bonds