Price discovery (as an element of market efficiency) is one of the cornerstones of market quality the other being market fairness. Research by the CMCRC illustrates how recent developments in Dark Trading in the Canadian stock market have affected the efficiency of these markets relative to their southern near neighbour market. We find that the implementation of IIROC Notice 12-0130, the first mandated limit on dark trading by a regulator, has resulted in increased price information in lit markets. However, limiting dark trading in Canada has reduced the efficiency of prices in Canada vis-s-vis US markets for cross listed stocks. IIROC Notice 12-013 came into force on the 15th of October 2012; prior to this dark trades where permitted to execute at the same price level as the Canadian best bid and offer, essentially free riding off the displayed limit orders. The new regulation forces dark trades to trade at either 1 full tick of p[rice improvement, or a half tick if the quotes are at the minimum spread except for block trades of 5,000 shares or more (or $100,000) which are not subject to the rule. This research uses a unique data set of dark trades collected from the four trading venues offering dark executions in Canada. This is combined with the Thomson Reuter’s tick history database to compare dark trading to lit trading. Following Hasbrouck (1995) and Gonzalo and Granger (1995) we separate price discovery into two measures: (1).Information Leadership Share, measuring the extent to which a venue produces new price information; and (2) Price Discovery Efficiency, the extent to which a venue avoids chasing temporary price shifts . Echoing past research, we find that dark trading adds little value in terms of price discovery contributing only 7.1% in terms of the Information Leadership Share. Furthermore, the introduction of price improvement rules in Canada reduces both the level of dark trading and the information content of dark trades. Analysing cross-listed securities, our research shows that limiting dark trading in Canada caused their price discovery to be less efficient compared to US trading, where dark trading caps do not exist. Price Discovery Efficiency reduced 19.4% after the introduction of the price improvement regulation. The research also explores the determinants of price discovery, specifically analysts’ recommendations and order book depth. We use the IBES broker recommendation database and Thomson Reuters Depth of book data to take a closer look at the variables which determine price discovery. We tackle two aspects. Firstly, we consider how the quality of the order book and analyst coverage affects the tendency of price discovery to occur in the dark or lit markets. Next we test how the quality of order books and coverage across borders moves price discovery between countries for cross-listed securities. We find that analyst coverage is not a predictor for price discovery; this makes sense given the ease of access to broker recommendations and information across markets. However, order book depth measures are strong predictors of price discovery. While these results demonstrate dark trading offers little in terms of price discovery, there may be a case that it can increase the aggregate price discovery of a markets, especially if there are differences in market regulation. This brings into question whether or not exchanges should allow dark traders to free ride off the price discovery and quotes of the lit market. Australia and Canada have both said no; but will Europe and the USA follow?
Author(s): Drew Harris