Dark Trading: Shedding Light on US and EU Regulation of the Securities Markets’ Dark Sector 9783110661873, 9783110661446

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Anna-Carina Salger Dark Trading

Anna-Carina Salger

Dark Trading

Shedding Light on US and EU Regulation of the Securities Markets’ Dark Sector

Anna-Carina Salger, Universität Wien

ISBN 978-3-11-066144-6 e-ISBN (PDF) 978-3-11-066187-3 e-ISBN (EPUB) 978-3-11-066209-2 Library of Congress Control Number: 2019951847 Bibliographic information published by the Deutsche Nationalbibliothek The Deutsche Nationalbibliothek lists this publication in the Deutsche Nationalbibliografie; detailed bibliographic data are available on the Internet at http://dnb.dnb.de. © 2020 Walter de Gruyter GmbH, Berlin/Boston Printing and binding: CPI books GmbH, Leck

www.degruyter.com

To my parents

Acknowledgements This thesis was admitted for the degree of Doctor of Law (doctor iuris) at the Albert Ludwigs University of Freiburg during the winter semester 2018/2019. It aims to state the law and major policy developments as of July 2019. Many people have contributed to the completion of this work. First and foremost, I am very grateful to my doctoral supervisor, Professor Dr. Hanno Merkt, LL.M., for his valuable support throughout my time as a student assistant and for his trust and encouragement during the writing process. I would also like to thank Professor Dr. Jan Lieder, LL.M. for swiftly providing the second review. The thesis is mainly based on research conducted during my stay as a visiting researcher at the Max Planck Institute for Comparative and International Private Law in Hamburg. I am deeply grateful for the valuable resources and opportunities that the institute offered me. Another large part of research was conducted during my studies at the University of Virginia School of Law. I would particularly like to thank Professor Andrew N. Vollmer who has substantially contributed to my insights and understanding of the US capital markets law and provided me with valuable input for my thesis. In the course of the development of this thesis, many people supported me in various ways. Among others, I would like to thank Katerina Siefkas, Chiara Tondi Resta, Madison Bush, Lauren Sandground, Johanna Claasen and Maria Julia Reh. This work would not have been possible without the unconditional faith and constant support of my parents, Andrea Salger und Dr. Carsten A. Salger. I dedicate this book to them. Anna-Carina Salger Hamburg, July 2019

https://doi.org/10.1515/9783110661873-001

Overview Introduction 1 A. Objectives and Approach B. Structure 4 Chapter 1

A. B. C. Chapter 2 A. B. C. Chapter 3 A. B. C. D. Chapter 4 A. B.

5 Rise of Dark Trading and its Classification Within the Market Structure 5 Definition and Classification of Dark Trading 6 24 The Rise of Dark Trading Conclusion to Chapter 1 48 51 The Impact of Dark Trading on The Market 51 Introduction to Evaluated Literature and Overview 67 Issues Raised in Regard to Dark Trading Conclusion to Chapter 2 114

53

119 Regulatory Approaches of Different Legal Systems 119 Overview of Different Regulatory Approaches 122 Regulation of Dark Trading in the US 128 174 Regulation of Dark Trading in the EU Conclusion to Chapter 3 237 239 Final Comparison and Recommendations Final Comparison 240 Future Prospects and Recommendations

Summary of the Final Conclusions Appendix – Literature Review Bibliography Index

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239 250

Contents Acronyms and Abbreviations

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Introduction 1 A. Objectives and Approach 4 B. Structure

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Chapter 1 5 Rise of Dark Trading and its Classification Within the Market Structure 5 6 A. Definition and Classification of Dark Trading I. Definition of Dark Trading 7 II. Dark Trading vs. Lit Trading 7 8 . Key Characteristics . Lit Venues 10 a. Public Securities Exchanges 11 13 b. Alternative Trading Systems III. Categories of Dark Trading 16 . Dark Orders 16 17 . Dark Pools a. Definition and Operation 17 b. Types of Dark Pools 20 . Broker-Dealer Internalization/Systematic Internalization 22 24 B. The Rise of Dark Trading I. Historical Development 26 . Technological Changes 26 a. Automated Trading and Algorithmic Trading 28 b. High-frequency Trading 29 c. Impact of HFT on the Market and the May 6th Flash Crash 34 d. Relation between High-frequency Trading and Dark Trading 36 . Regulatory Changes 38 a. US Market 38 b. EU Market 42 . Globalization 44 II. Other Factors 45 C. Conclusion to Chapter 1 48

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Chapter 2 51 51 The Impact of Dark Trading on The Market A. Introduction to Evaluated Literature and Overview 53 I. Categorization of Literature 54 II. Overview of Main Issues 57 60 . Primary Objectives of Securities Regulation a. Investor Protection 60 61 b. Market Efficiency c. Market Quality 62 d. Market Integrity 62 63 e. Market Stability . Specification of Harms and Benefits 64 . Objectives and Interests Affected by Dark Trading 64 67 B. Issues Raised in Regard to Dark Trading I. Lack of Transparency and Impact on Price Discovery 67 . A Security’s Price 68 71 . Price Discovery and Price Formation . Impact of Dark Trading on Price Discovery 72 a. Impact Due to Lack of Transparency 72 b. Impact Due to Reference Pricing 75 78 . Analysis of Academic Literature II. Impact due to the Facilitation of Market Fragmentation 83 . Dark Trading and Fragmentation 84 84 . Impact of Dark Fragmentation a. Impact of Dark Fragmentation on Liquidity 85 b. Impact of Dark Fragmentation on Stock Market Indices 88 . Analysis of Academic Literature 90 III. Fair Access to Information and Trading Venues 94 . Impact Due to Lack of Information 95 a. Informational Asymmetries Between Lit Traders and Dark Traders 96 b. Informational Asymmetries Among Dark Traders 97 . Impact Due to Discretionary Access Rules 97 . Analysis of Academic Literature 99 101 IV. Impact by Predatory Trading Strategies . Predatory Trading Strategies 105 a. Strategies to Exploit Price Discrepancies 106 b. Strategies to Influence the Prices 108

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. Impact due to Lack of Transparency and Supervision 111 . Analysis of Academic Literature C. Conclusion to Chapter 2 114

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Chapter 3 119 119 Regulatory Approaches of Different Legal Systems A. Overview of Different Regulatory Approaches 122 123 I. Core Elements of Dark Trading Regulation II. The Regulatory Environment of the Major Jurisdictions 124 B. Regulation of Dark Trading in the US 128 129 I. The SEC’s Regulation of Dark Trading . Regulation ATS of 1998 130 a. Definition of Alternative Trading System 132 132 b. Registration Requirements c. General Requirements and SRO Membership 133 d. Transparency Requirements 134 134 e. Fair Access f. Critique and Conclusion 134 . Regulation NMS of 2005 136 a. Order Protection Rule 137 138 b. Access Rule c. Sub-Penny Rule 139 d. Amended Market Data Rules 140 141 e. Critique and Conclusion . Latest Regulatory Proposals by the SEC 144 a. Proposal to Integrate Dark Pools Into the NMS 144 b. Proposal of Trade-at Rule 148 c. Proposal to Enhance Transparency and Oversight of ATSs 150 d. Proposal to Enhance Order Handling Information 152 e. Critique and Conclusion 154 II. FINRA’s Regulation of Dark Trading 154 III. Enforcement Actions and Case Law Analysis 157 . Legal Basis and General Liability Rules 157 . The Enforcement Actions 160 160 a. In the Matter of Pipeline Trading b. In the Matter of eBX 162 c. In the Matter of Liquidnet 163 d. In the Matter of UBS 164 e. In the Matter of ITG 165

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f. In the Matter of Credit Suisse 166 167 g. In the Matter of Barclays Capital h. In the Matter of Deutsche Bank 169 . Conclusion 171 IV. Critique and Conclusion on US Regulation 172 174 C. Regulation of Dark Trading in the EU I. The Original MiFID of 2004 177 179 . Main Regulatory Achievements a. Abolition of the Concentration Rule 179 b. New Categories of Trading Venues 179 181 c. Enhanced Transparency Regime . Remaining Gaps and New Challenges 184 II. MiFID II and MiFIR 186 . Overview of Legislative Process, Regulatory Concept, Timeframe 187 and Transposition into National Laws a. Legislative Process 188 189 b. Regulatory Concept c. Timeframe 192 d. Transposition of MiFID II/MiFIR into National Laws 192 . The Role of ESMA 194 a. Level 2 – Technical Advice and Binding Technical 195 Standards b. Level 3 – Guidelines and Recommendations 196 197 c. Level 4 – Supervisory and Enforcement Power . Regulatory Changes and New Provisions under MiFID II/ MiFIR 199 a. Regulatory Changes to Classification of Multilateral Trading Venues and Introduction of Organized Trading Facilities 200 b. Regulatory Changes for Systematic Internalizers 206 c. Trading Obligation 208 d. Enhanced Transparency Regime and Changes to Transparency Waivers 209 e. Double Volume Caps for Dark Trading 216 f. Distribution and Consolidation of Trading Data 218 222 g. Regulation of Algorithmic Trading and HFT . Critique and Conclusion on the MiFID II/MiFIR Regime 227 a. Venue Classification 228 b. Transparency Regime 229 c. Double Volume Caps 230

Contents

d. Regulation of HFT 234 e. General Critique and Conclusion D. Conclusion to Chapter 3 237

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Chapter 4 239 239 Final Comparison and Recommendations A. Final Comparison 240 241 I. Categorization of Trading Venues II. Transparency Regimes 242 III. Price Discovery and Fair Access 243 245 IV. Data Consolidation V. Algorithmic Trading Practices and HFT 246 VI. Supervision 247 248 VII. Conclusion B. Future Prospects and Recommendations 250 I. Dark Trading is Not the Sole Cause for Market Failure 250 251 II. Regulators Should Consider the Benefits and Incentives III. Unlimited Transparency is Not a Sufficient Solution 253 IV. Regulation of Trading Practices and HFT 255 V. The Type of Regulation Matters 256 258 VI. Regulatory Intervention Should be Simple and Exceptional VII. Conclusion 260 Summary of the Final Conclusions 261 Conclusions on the development and the classification of dark trading:  Conclusions on the impact of dark trading on the market and market participants:  Conclusions on the comparison of the regulatory approaches in the US and the EU:  Conclusion on the assessment of the regulatory approaches taking into consideration the economic findings  Appendix – Literature Review Bibliography Index

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Acronyms and Abbreviations APA Apr. ARM Art. ASIC ATS AUD Aug. BaFin Barclays BBO BKR BoersG Brook. J. Corp. Fin. & Com. L. BTS Bus. Ethics Q. C.F.R. CAD CESR cf. CFTC Ch. Chicago-Kent L. Rev. Colum. J.L. & Soc. Probs. Commun. ACM Credit Suisse CSA CTA Plan CTP Curr. Pol. & Econ. Europe DAX DB Dec. DePaul Bus. & Com. L. J. Deutsche Bank DJIA

Approved Publication Arrangements, defined in Art. 4(1)(52) MiFID II April Approved Reporting Mechanism Article(s) Australian Securities and Investments Commission Alternative trading system Australian Dollar August Bundesanstalt für Finanzdienstleistungsaufsicht (Federal Financial Supervisory Authority) Barclays Capital, Inc. Best Bid and Offer (see also NBBO and EBBO) Zeitschrift für Bank und Kapitalmarktrecht (journal) Boersengesetz (German Stock Exchange Act) Brooklyn Journal of Corporate, Financial & Commercial Law Binding Technical Standards Business Ethics Quarterly Code of Federal Regulations Canadian Dollars Committee of European Securities Regulators confer US Commodity Futures Trading Commission Chapter Chicago-Kent Law Review Columbia Journal of Law and Social Problems Communications of the ACM (journal) Credit Suisse Securities (USA), LLC Canadian Securities Administrators Consolidated Tape Association Plan Consolidated Tape Provider Current Politics and Economics of Europe Deutscher Aktienindex (German stock market index) Der Betrieb (journal) December DePaul Business & Commercial Law Journal Deutsche Bank Securities, Inc. Dow Jones Industrial Average

https://doi.org/10.1515/9783110661873-002

XVIII

Acronyms and Abbreviations

DPRM

e. g. EBBO eBX ECN Econ. Theory ed. Ed(s). EMSAC ESMA ESMA Regulation et al. et seq(q). EU EU legislator Eur. Bus. Org. L. Rev. FAJ FCA Feb. FESE FINRA Fla. L. Rev. Fordham L. Rev. FTSE 100 G20 HFT i. e. ICLQ Id. IFLR IIROC IOI IOSCO IRFA ITG ITS J. Banking & Finance J. Fin. Econ. J. Finance J. High Tech. L. J. Int’l Bus. & L. J. Legal Stud. J.L. & Econ. Jan.

Dark Pool Ranking Model (algorithm component of order routing system used by Deutsche Bank as referred to in SEC’s order In the Matter of Deutsche Bank) exempli gratia European Best Bid and Offer eBX, LLC Electronic Communication Network Economic Theory (journal) edition Editor(s) Equity Market Structure Advisory Committee (formed by the SEC) European Securities and Markets Authority EU Regulation No. 1095/2010 et alii/ et aliae and the following page(s)/ article(s) European Union European Commission European Business Organization Law Review Financial Analysts Journal Financial Conduct Authority Feburary Federation of European Securities Exchanges Financial Industry Regulatory Authority Florida Law Review Fordham Law Review Financial Times Stock Exchange 100 Index The Group of Twenty High-frequency trading id est International & Comparative Law Quarterly Idem International Financial Law Review Investment Industry Regulatory Organization of Canada Indication of Interest International Organization of Securities Commission International Review of Financial Analysis Investment Technology Group Inc. and its affiliate AlterNet Securities Implementing Technical Standards Journal of Banking and Finance Journal of Financial Economics Journal of Finance Journal of High Technology Law Journal of International Business and Law Journal of Legal Studies Journal of Law & Economics January

Acronyms and Abbreviations

Law & Pol’y Int’l Bus. LFMR LFT Liquidnet LIS LSE MAD

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Law and Policy in International Business Law of Financial Markets Review Low-frequency trading Liquidnet, Inc. Large-in-scale (Art. 4(1)(c) MiFIR; Art. 7(1) of RTS 1) London Stock Exchange 2014 Market Abuse Directive (Directive 2014/57/EU of 16 April 2014 on criminal sanctions for market abuse) MAR 2014 Market Abuse Regulation (Regulation (EU) No 596/2014 of 16 April 2014 on market abuse) Mar. March MDAX Mid-Cap-DAX (German stock market index), see DAX MiFID I Directive 2004/39/EC of 21 April 2004 on markets in financial instruments MiFID II Directive 2014/65/EU of 15 May 2014 on markets in financial instruments MiFIR Regulation (EU) No 600/2014 of May on markets in financial instruments MTF Multilateral trading facility, defined in Art. 4(1)(22) MiFID II MTTLR Michigan Telecommunications and Technology Law Review NASDAQ National Association of Securities Dealers Automated Quotations Nasdaq UTP Plan’ Joint Self-Regulatory Organization Plan Governing the Collection, Consolidation, and Dissemination of Quotation and Transaction Information for Nasdaq-Listed Securities Traded on Exchanges on an Unlisted Trading Privileges Basis NBBO National best bid and offer, defined in 17 C.F.R. § 242.600(b)(42) NMS National Market System Nov. November Nw. Interdisc. L. Rev. Northwestern Interdiciplinary Law Review NY AG New York State Attorney General NYSE New York Stock Exchange Oct. October OTC Over-the-counter OTF Organized Trading Facility, defined in Art. 4(1)(23) MiFID II Oxford J. Legal Studies Oxford Journal of Legal Studies Para. Paragraph(s) PBBO Primary Best Bid and Offer Pipeline Trading Pipeline Trading Systems, LLC Public Finance Quarterly Journal of Public Finance Published Quarterly QJE The Quarterly Journal of Economics Rec. Recital(s) Regulation ATS Regulation Alternative Trading System Regulation NMS Regulation National Market System Rev. Banking & Fin. L. Review of Banking and Financial Law RF Review of Finance RFS Review of Financial Studies RIBAF Research in International Business and Finance

XX

Acronyms and Abbreviations

RM RTS SA SEA SEC Sec. Sept. SETS SI SIP SRO Stan. J.L. Bus. & Fin. Suffolk U. L. Rev. TEU TFEU TRF Trinity C.L. Rev. U. Rich. L. Rev. UBS US Va. L. & Bus. Rev. Vand. L. Rev. Vol. Vt. L. Rev. WM WpHG Xetra ZBB ZVglRWiss

Regulated market, defined in Art. 4(1)(21) MiFID II Regulatory Technical Standards US Securities Act of 1933 US Securities Exchange Act of 1934 Securities Exchange Commission of the United States Section September Stock Exchange electronic Trading Service Systematic internalizer, defined in Art. 4(1)(20) MiFID II Securities Information Processor Self-regulatory organization Stanford Journal of Law, Business & Finance Suffolk University Law Review Treaty on European Union Treaty on the Functioning of the European Union Trade Reporting Facility Trinity College Law Review University of Richmond Law Review UBS Securities LLC United States Virginia Law and Business Review Vanderbilt Law Review Volume Vermont Law Review Wertpapier-Mitteilungen Zeitschrift für Wirtschafts- und Bankrecht (journal) Wertpapierhandelsgesetz (German Securities Trading Act) Exchange Electronic Trading Zeitschrift für Bankrecht und Bankwirtschaft (journal) Zeitschrift für Vergleichende Rechtswissenschaft (journal)

Introduction A. Objectives and Approach Over the past decades, securities market structures have undergone profound changes, undermining the achievement of the primary goal of securities regulation – the creation of a level playing field. The transformation was particularly apparent in secondary markets, where trades that had been conducted largely through telecommunication were now executed by electronic trading, thereby allowing the automation of the transaction process.¹ About 50 years ago, the first automated trading system emerged, replacing trading floors and market makers by using mathematical algorithms to match orders electronically.² Since then, due to technological innovations and regulatory changes, the development of automated trading venues has increased. Trading in listed stocks, which used to be heavily concentrated on the public exchanges, is now widely dispersed among multiple automated trading venues. These venues vary immensely in their operation and functionality. They are therefore commonly referred to as ‘alternative trading venues’. While public exchanges are subject to comprehensive transparency requirements and have to publicly disclose trading information, including orders available for execution, prices of the securities, and investors participating in transactions, a number of alternative trading venues are exempt from these transparency requirements. Thus, they are attributable to the over-the-counter (OTC) sector. Moreover, many alternative trading venues disclose very little information about their operation and often function in great secrecy.³ Due to their characteristics, they are also commonly known as ‘dark pools’. Trading conducted on those dark pools is considered to be one form of ‘dark trading’. Dark trading is not an entirely new phenomenon. It has taken place in the markets for decades, mostly known in the form of ‘upstairs trading’, where brokers execute orders, for instance, against the firm’s own inventory. In recent years,

 Financial Conduct Authority, TR16/5: UK equity market dark pools – Role, promotion and oversight in wholesale markets (July 2016), 7.  Commissioner Stein, Statement on Adoption of Rules to Increase the Operational Transparency of Alternative Trading Systems (ATS), SEC (July 18, 2018), https://www.sec.gov/news/publicstatement/statement-stein-071818 -1#_ftn4 (last visited Sept. 25, 2018); Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 1.  Commissioner Stein, Statement on Adoption of Rules to Increase the Operational Transparency of Alternative Trading Systems (ATS), SEC (July 18, 2018), https://www.sec.gov/news/publicstatement/statement-stein-071818 -1#_ftn4 (last visited Sept. 25, 2018). https://doi.org/10.1515/9783110661873-003

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Introduction

the amount of dark trading has increased rapidly. While over ten years ago, approximately eighty percent of stock trading in the US occurred on the New York Stock Exchange (NYSE), the volume declined to about twenty percent in 2014, loosing most of the trades to alternative trading venues.⁴ Today, dark trading volume accounts for over forty percent in the US and for about eight percent in the EU (in contrast to one percent in 2009).⁵ Consequently, dark trading gained more and more attention of market participants and regulators. In addition, the SEC’s investigations into dark pools that unveiled misconduct violating securities laws and the heated discussions after the publication of Michael Lewis’ bestseller ‘Flash Boys’ have spurred the public’s concern about dark trading and, in particular, dark pools. According to Lewis, “[d]ark pools were another rogue spawn of the new financial marketplace”.⁶ “No outsider could see what went on inside them. It was entirely possible that a broker’s own traders were trading against the customers in its dark pool: There were no rules against doing that.” ⁷ However, the trading industry is divided as to whether dark trading is actually harmful to the market and experts disagree on the impact of dark trading on the market and market participants. While some argue that dark trading has a negative impact on transparency and price discovery, others highlight the benefits, particularly for institutional investors, including the prevention of information leakage and reduced trading costs.“When you get to the heart of what dark pools are about, there is not really anything that would be considered to be shady practice about their operations. In fact, quite the contrary – they represent a very efficient way of bringing together buyers and sellers of large blocks of a particular stock to create that one thing considered to be the Holy Grail in equity markets – liquidity.” ⁸ The financial crisis has exposed deficiencies in the regulation of the securities markets, particularly in regard to market stability and the management of systemic risks. Today, about ten years after the financial crisis, market partici-

 Garcia, This NYSE Plan Could Help Retail Investors, Market Watch (Dec. 24, 2014), https:// www.marketwatch.com/story/this-nyse-plan-could-help-retail-investors-2014-12-24 (last visited Sept. 25, 2018).  Bogard, TABB Equity Digest: Q2– 2016, Quarterly Report (Dec. 8, 2016), https://research. tabbgroup.com/report/v14– 071-tabb-equity-digest-q2– 2016 (last visited Sept. 25, 2018); Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 3.  Lewis, Flash Boys, 42.  Lewis, The Wolf Hunters of Wall Street (Mar. 31, 2014), https://www.nytimes.com/2014/04/06/ magazine/flash-boys-michael-lewis.html (last visited Sept. 25, 2018).  Oughton, Dark Pools Bad, Light Pools Good? Its Not That Simple!, Wolters Kluwer Financial Services (May 12, 2016), http://www.wolterskluwerfs.com/article/dark-pools-bad-light-pools-good-itsnot-that-simple.aspx (last visited Sept. 25, 2018).

A. Objectives and Approach

3

pants and regulators are concerned about the efficient functioning of the markets and the decreases in transparency, fairness and supervision.⁹ As a result, the regulation of trading practices and trading venues, particularly off-exchange trading venues, has come under tremendous scrutiny. Driven by the primary objectives of securities regulation and the common principles, international reform agendas are designed to: (1) minimize the adverse impact of the increased use of dark pools and dark orders on the price discovery process in transparent markets, (2) mitigate the effect of any potential fragmentation of information and liquidity, (3) help to ensure that regulators have access to adequate information to monitor the use of dark pools and dark orders, (4) help to ensure that investors have sufficient information in order for them to be able to understand the manner in which orders will be handled and executed, and (5) increase the monitoring of dark orders and dark pools in order to facilitate an appropriate regulatory response.¹⁰ Although the lack of efficiency of securities markets and other related concerns are attributed to dark trading, it is not the sole cause for the issues and, in that regard, is unfairly criticized. The current market structure has also been highly influenced by two other factors: The increasing market fragmentation due to the vast variety of trading venues, competing with each other over trading liquidity, and the growth of high-frequency trading, a form of algorithmic trading, that enabled the emergence of new trading practices, some of which severely harm other traders. Overall, the current structure of the securities markets in the US and the EU can be described as (1) highly technical and complex, (2) vastly fragmented, (3) with a high level of trading in the dark sector. While the consequences of the technical complexity and market fragmentation have already been analyzed by market participants and scholars in the past, the third characteristic has only recently given rise to concerns. The topic of this study touches on an interdisciplinary field between economics and law, where both disciplines influence each other. Thus, a thorough analysis of economic studies, providing information about the economic reality, is essential to designing and establishing an effective and efficient regulatory framework. Although dark trading has been subject to some economic studies, a legal assessment in view of these economic findings is still missing from the discussion. This study aims to fill this gap by providing a comparative legal analysis of the regulatory systems of the US and the EU, taking into account the economic findings. The comparative analysis provides a valuable contribution to the

 Cf. Donald, 16 Eur. Bus. Org. L. Rev. (2015), 173, 175.  IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 24.

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Introduction

establishment of international harmonized regulation of securities markets to achieve the primary goal of creating a level playing field. The focus of this study is solely on dark trading and the associated concerns and risks. While other aspects, such as high frequency trading and market fragmentation are also examined, as far as they concern dark trading, a detailed analysis of the associated risks would go beyond the scope of this study. Furthermore, the comparative legal analysis concentrates on the regulatory frameworks of the US and the EU, since these are the most important markets with regard to dark trading. It primarily assesses the regulation of equity instruments, as they currently constitute the main investments conducted by dark trading.

B. Structure After a brief introduction the study is divided into four chapters followed by a summary of the final conclusions. Chapter 1 introduces the different terminology in the EU and the US in regard to trading venues and provides a distinction between dark trading and lit trading, thereby setting forth the different forms of dark trading. Furthermore, it outlines the technological development, historical events and regulatory steps in the US and the EU that caused for changes in the market structure and laid the foundations of the legislative frameworks in their current form. It also discusses the emergence of dark trading in the US market and the EU market and analyzes the primary causes of the increase in demand for dark trading. Chapter 2 sets forth the primary objectives of securities regulation and provides an assessment of empirical and theoretical studies analyzing the impact of dark trading on the securities markets. It focuses on the issues caused by the lack of transparency, the facilitation of market fragmentation, the restrictions on access to information and trading venues and the use of predatory trading strategies. The main purpose of Chapter 2 is to define the key issues caused by dark trading and to be addressed by regulators. It sets forth the economic basis for the following comparative regulatory analysis and future prospects. Chapter 3 provides an overview of the different regulatory frameworks, focusing on the US system and the EU system, and assesses in more detail the regulations specifically addressing dark trading. Chapter 4 discusses the similarities and differences of the US system and the EU system with regard to the regulation of dark trading in view of the primary objectives of securities regulation, in order to reveal the regulatory gaps that require further action and regulatory intervention. It concludes with an analysis of future prospects and further recommendations. The study closes with a summary of the final conclusions.

Chapter 1 Rise of Dark Trading and its Classification Within the Market Structure Over the past decade, technological developments, regulatory changes, and increasing globalization led to significant structural changes in the securities markets and the trading industry worldwide.¹ On the one hand, technologies enabling high-frequency trading offered new possibilities to trade at speeds human beings cannot longer compete with. On the other hand, new regulations opening the markets for off-exchange trading offered a way to escape from highfrequency traders and thereby caused an increase of competition and market fragmentation.² Consequently, the overall liquidity has become increasingly fragmented over these multiple trading venues accompanied by a general shift of trading volume away from the public exchanges towards off-exchange trading venues.³ The traditional public exchanges are generally transparent, because the orders they match are usually visible to the market participants and executed transactions are posted to the public immediately, and thus are also referred to as ‘lit venues’.⁴ In contrast, off-exchange trading venues, allocated to the over-the-counter (OTC) sector, do not have the same transparency requirements, and thus are mainly non-displayed, a characteristic that is described as ‘dark’ contrary to ‘lit’.⁵

 See Preece/Rosov, 70 FAJ (2014), 33, 33 referring to the US as an example; Coffee/Sale/Henderson, Securities Regulation, 601.  ‘Market fragmentation’ is a term used to describe the situation that multiple and geographically separated forums in which trading in the security occurs exist in one market. See SEC, Development of a National Market System, Securities Exchange Act Release No. 14,416, 43 Fed. Reg. 4354 (Feb. 1, 1978).  Preece/Rosov, 70 FAJ (2014), 33, 33.  Clarke, 8 LFMR (2014), 342, 347; Francioni/Reck/Schwartz, Secondary Market: Trading, Price Discovery, and Order Matching, in: Francioni/Schwartz, Equity Markets in Transition, 85, 121; Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 6; Palmer, Dark and Lit Markets: A User’s Guide, Institutional Investor Journals (2010), www.ii news.com/site/pdfs/liquidityii_flextrade.pdf (last visited Sept. 25, 2018).  Gadinis, 3 Va. L. & Bus. Rev. (2008), 311– 356, 320; Francioni/Reck/Schwartz, Secondary Market: Trading, Price Discovery, and Order Matching, in: Francioni/Schwartz, Equity Markets in Transition, 85, 121; Palmer, Dark and Lit Markets: A User’s Guide, Institutional Investor Journals (2010), www.iinews.com/site/pdfs/liquidityii_flextrade.pdf (last visited Sept. 25, 2018). https://doi.org/10.1515/9783110661873-004

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Chapter 1

This chapter first provides a definition of the term ‘dark trading’ and explains in further detail the different categories and its classification within the market structure (A.). Second, it points out the major historical developments and, in particular, its relation to high-frequency trading (B.), which are necessary to understand why dark trading plays an important role in today’s securities markets and why it is gaining increasing attention. The third part (C.) sums up the main conclusions.

A. Definition and Classification of Dark Trading Dark trading sounds very ominous and, in contrast to lit trading, naturally tends to have a negative connotation. The term ‘dark’ is often used to describe unregulated areas with the potential to facilitate criminal activity because they are difficult to supervise.⁶ Although dark trading is proven to provide some benefits to the markets, so it is not harmful per se, there is some truth to its negative reputation as well. The following part defines the term ‘dark trading’ (I.), assesses what makes trading dark in contrast to lit trading (II.), and sets forth the different categories and types of dark trading (III.). Today, dark trading appears in every securities market, more or less in all its variations. However, the international legal systems differ in regard to the classification and the legal terminology. For concreteness, the following explanations are tailored to the legal terms used in the regulatory framework of the United States (US).⁷ References to the equivalents in other legal systems, particularly the system of the European Union (EU), are made if necessary. The details of the differences in the venue classification are discussed in Chapter 3 within the context of each regulatory framework.

 For example, the ‘dark net’ which is a collection of networks and technologies used to share digital content, such as peer-to-peer file sharing and CD or DVD copying, usually illegal activities, see Biddle/England/Peinado/Willman, The Darknet and the Future of Content Distribution, Microsoft Corporation (Nov. 18, 2002), https://crypto.stanford.edu/DRM2002/darknet5.doc (last visited Sept. 25, 2018).  Although the terminology differs substantially among the EU and the US Europe, the characteristics of the trading venues and trading functionalities are very similar in practice. Cf. Gadinis, 3 Va. L. & Bus. Rev. (2008), 311– 356, 333. Since dark trading was first addressed in the US, most of the related academic literature refers to the US market and uses US terminology. Thus, for practical reasons this study is also based on the US terms but compares it to the EU terminology and points out the similarities and differences.

A. Definition and Classification of Dark Trading

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I. Definition of Dark Trading Dark trading is a rather visualized description of trading whereby trades are being executed without revealing information, for example, about submitted orders, prices and the investors participating, at least prior to the execution of a trade.⁸ It usually occurs in the form of off-exchange trading on dark venues or in the form of hidden orders on otherwise lit venues.⁹ Although dark trading just recently gained remarkable attention, it is not an entirely new phenomenon but has long existed in form of upstairs trading, where brokers, instead of routing an incoming order to an exchange for execution, filled the order, for instance, with the firm’s own inventory.¹⁰ Traders have always sought ways to preserve anonymity and execute orders with minimal market impact.¹¹ However, the variety of types of dark trading has increased rapidly, causing a rise in the amount of dark trading in the securities markets and attracting much more attention to this practice.

II. Dark Trading vs. Lit Trading In order to understand what makes trading ‘dark’, it is important to take a closer look at its key characteristics and its counterpart, ‘lit trading’. Put in simple terms, trading requires the execution of two matching orders, an order to sell and an order to buy. Therefore, the participants first need a market¹² and a market place, i. e. a trading venue, where they can meet and submit their orders.

 Degryse/de Jong/van Kervel, 19 RF (2015), 1587, 1589; Gadinis, 3 Va. L. & Bus. Rev. (2008), 311– 356, 320 – 321.  Degryse/de Jong/van Kervel, 19 RF (2015), 1587, 1589. See below in section A.II. and III. for distinction between dark and lit venues and further details.  IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 4; Zaza, 18 Stan. J.L. Bus. & Fin. (2013), 319, 323.  IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 4. Market impact is the expected price change conditioned on initiating a trade of a given size and a given sign, i. e. initiating a buy order should drive the price up, initiating a sell order should drive the price down. See Moro/Vicente/Moyano/Gerig et al., Market impact and trading profile of large trading orders in stock markets (Aug. 3, 2009), 5.  While the term ‘market’ applies to a variety of meanings, including the securities markets, but also sectors within the securities markets or trading venues, this study refers to the term ‘market’ solely in its description of the securities markets in general. Differences, in particular between the US market and the EU market, are pointed out respectively.

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There are several kinds of trading venues participants can choose from.¹³ Second, the participants need information about available trading opportunities to find out who they can trade with and to determine the price reflecting the value of the respective security. If all this information is revealed to the public the market place is considered to be ‘lit’.

1. Key Characteristics Deriving from the general explanation above, the key characteristics of lit trading can be summarized as transparency and price discovery. Basically, a trading venue is lit if the liquidity available, i. e. its orders and quotes, is openly displayed and thus transparent to the general public, particularly before trades are executed, and dark if it is not.¹⁴ While in a lit venue the participants can observe the orders submitted by other participants, in dark venues, all orders are hidden.¹⁵ Since the liquidity is not displayed in a dark venue, market participants cannot immediately find out whether there are other orders available matching their orders. In order to achieve transparency, lit venues are required to publish not only post-trade but also pre-trade order information.¹⁶ When an investor places an order to buy or sell on a ‘lit’ venue in the US registered with the SEC, the venue makes this quote available to the public by sending it to the ‘consolidated tape’, a high-speed, electronic system which publicly displays current prices and real-time volume data on sales of exchange-traded securities.¹⁷ The Consolidated  Generally, the term ‘trading venue’ covers any formal and informal systems, bilateral and multilateral, on which trading can be organized. Cf. Moloney, EU Securities and Financial Markets Regulation, 426 note 4.  Cf. Kratz/Schöneborn, 14 Quantitative Finance (2014), 1519, 1519; Palmer, Dark and Lit Markets: A User’s Guide, Institutional Investor Journals (2010), www.iinews.com/site/pdfs/liquid ityii_flextrade.pdf (last visited Sept. 25, 2018); Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 332– 333.  Financial Conduct Authority, Asymmetries in Dark Pool References Prices (Sept. 2016), 4.  Shorter/Miller, Dark Pools in Equity Trading: Policy Concerns and Recent Developments (Sept. 26, 2014), 2; cf. Art. 3, 6 and 8, 10 of the Regulation (EU) No 600/2014 of 15 May 2014 on markets in financial instruments (MiFIR) providing transparency requirements for venues in the EU trading in equity/equity-like and non-equity instruments. For the US see 17 C.F.R. § 242.602 and § 242.603.  Cf. definition provided by the SEC, available at https://www.sec.gov/fast-answers/answer sconsolthtm.html (last visited Sept. 25, 2018); Karmel, High-Frequency Trading, Direct Electronic Access and Dark Pools, New York Law Journal (Dec. 15, 2011), https://www.brooklaw.edu/news andevents/news/2012/~/media/507015B01660487D95CA341F93376E38.ashx (last visited Sept. 25, 2018).

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Tape Association oversees the Consolidated Tape System and the Consolidated Quotation System which provide data streams about real-time trade and quote information.¹⁸ Using the data sent to the systems, the Security Information Processor (SIP), registered with the SEC under Section 11 A of the Securities Exchange Act of 1934 (SEA)¹⁹, calculates the national best bid and offer (NBBO) for securities and presents it to the public on the screens. In the EU, unlike in the US, there is no publicly available standardized and consolidated detailed trading information for all venues.²⁰ Rather, the European lit venues individually provide their own data feeds and make their trade and quote information available separately.²¹ However, the European regulator has taken measures to harmonize the transparency requirements when implementing the first Markets in Financial Instruments Directive (MiFID I)²². Accordingly, the provisions under MiFID I required the Member States to implement rules to ensure that regulated markets publish current bid and offer prices and the depth of trading interests, summarized as pre-trade transparency requirements, and to publish price, volume and time of the transactions as close to real-time as possible, contributing to post-trade transparency.²³ Under the new regime comprised of a second Directive on Markets in Financial Instruments (MiFID II)²⁴ and the accompanying Markets in Financial Instruments Regulation (MiFIR)²⁵, both adopted in 2014, the EU regulator also introduced rules governing how consolidation is to be done.²⁶ However, in contrast to the US, there is no monopoly provider but several ‘consolidated tape providers’ competing to consolidate data. Moreover, the regulatory regime applies only to post-trade data.²⁷

 See the overview of the Consolidated Tape Association, available at https://www.ctaplan. com/index (last visited Sept. 25, 2018).  Details of the regulation of SIPs are set forth in 15 U.S.C. § 78k–1.  After a review of the MiFID I regime several consolidation options were discussed in the wake of MiFID II. The EU regulator adopted rules governing how consolidation is to be done. However, in contrast to the US, there is no monopoly provider but several ‘consolidated tape providers’ competing to consolidate data. Moreover, the regulatory regime applies only to post-trade data. See Moloney, EU Securities and Financial Markets Regulation, 494.  Moloney, EU Securities and Financial Markets Regulation, 494– 495.  Directive 2004/39/EC of 21 April 2004 on markets in financial instruments (MiFID I), published in Official Journal of the European Union, L 145/1 (April 4, 2004).  Art. 44, 45 MiFID I.  Directive 2014/65/EU of 15 May 2014 on markets in financial instruments (MiFID II).  Regulation (EU) No 600/2014 of 15 May 2014 on markets in financial instruments (MiFIR).  See for example Art. 12(1), 13(1) MiFIR. More details are provided in Ch. 3 (C.II.).  Moloney, EU Securities and Financial Markets Regulation, 494.

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The other key characteristic of lit venues is that they provide and facilitate price discovery.²⁸ While lit venues determine the prices at which trades are executed according to the trading interests, i. e. supply and demand, as reflected in the amount of incoming orders²⁹, dark venues often adopt these prices and use them as a reference.³⁰ Thus, dark trading may cause little or no price impact if trades are executed on a dark venue.³¹ However, there are shades of darkness in lit venues as well which make it more complicated to distinguish them.³² The next part is an attempt to do so and provides an overview of the main lit venues.

2. Lit Venues The execution of orders can take place on different kinds of trading venues.³³ Due to the developments in the financial market infrastructure over the past decades, the variety of different trading venues increased.³⁴ They can be distinguished according to their trading functionalities, the services they provide, and other factors, or simply between two broad categories: (1) formal/organized, multilateral, non-discretionary, and ‘lit’ venues or (2) informal, bilateral, discretionary, and ‘dark’ venues.³⁵ The following part provides an overview of the different types of the first category, the ‘lit’ venues, and their operation and function. Lit venues basically occur in the form of either public securities exchanges (a.) or alternative trading venues (b.).

 Francioni/Reck/Schwartz, Secondary Market: Trading, Price Discovery, and Order Matching, in: Francioni/Schwartz, Equity Markets in Transition, 85, 86.  IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 19; O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 107. This is a very plain but vague description of price discovery. Details about the price discovery process are provided in Ch. 2 (B.I.2.).  Financial Conduct Authority, Asymmetries in Dark Pool References Prices (Sept. 2016), 9, 13; Kratz/Schöneborn, 14 Quantitative Finance (2014), 1519, 1519; Zhu, 27 RFS (2014), 747, 753.  Kratz/Schöneborn, 14 Quantitative Finance (2014), 1519, 1519.  Palmer, Dark and Lit Markets: A User’s Guide, Institutional Investor Journals (2010), www.ii news.com/site/pdfs/liquidityii_flextrade.pdf (last visited Sept. 25, 2018).  Moloney, EU Securities and Financial Markets Regulation, 426; Choi/Pritchard, Securities Regulation, 11.  Moloney, EU Securities and Financial Markets Regulation, 427; cf. Coffee/Sale/Henderson, Securities Regulation, 602.  This kind of distinction is made by Moloney, EU Securities and Financial Markets Regulation, 427.

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a. Public Securities Exchanges The best-known example of a venue falling under the first category is the traditional stock exchange such as the New York Stock Exchange (NYSE), the London Stock Exchange (LSE), and Deutsche Boerse. They are classified as national securities exchanges³⁶, or as regulated markets (RM), an equivalent used in the EU regulatory context. According to the European regulation, a ‘regulated market’ is a system which is operated and/or managed by market operator, and brings together, or facilitates the bringing together of, multiple third party buying and selling interests in financial instruments – in the system and in accordance with its non-discretionary rules – in a way that results in a contract, in respect to the financial instruments admitted to trade under its rules and/or systems”, and which is authorized and functions regularly in accordance with rules of the respective regulatory framework.³⁷ Lit exchanges operate as order books where bid and offer orders are collected and cumulated and prices are determined by supply and demand.³⁸ They establish legal relationships with the issuers of admitted securities and trading participants.³⁹ Traders can select between placing a market order, which is executed immediately according to the volumes and prices available, or a limit order, which is added to the order book as part of supply or demand and will be executed at a certain desired price outside the current best bid and offer.⁴⁰ The order book shows the volumes of the stock available for sale and for purchase at different prices. Typically, the securities exchanges have an opening and closing auction, and enable continuous and anonymous trading through the limit order book.⁴¹ The transactions are concluded based on an approved set of rules and are supervised by the bodies of the exchange and the competent regulators.⁴² Further, the public securities exchanges have to fulfill certain requirements in order to contribute to transparency, market quality and investor protection. In

 See Sec. 6 of the Securities Exchange Act of 1934.  Art. 4(1)(21) MiFID II. See also Moloney, EU Securities and Financial Markets Regulation, 463.  Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 16; Francioni, An Exchange and Its Value, in: Francioni/Schwartz, Equity Markets in Transition, 15 – 69, 34.  Francioni, An Exchange and Its Value, in: Francioni/Schwartz, Equity Markets in Transition, 15 – 69, 62.  Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 16.  Degryse/de Jong/van Kervel, 19 RF (2015), 1587, 1593.  Francioni, An Exchange and Its Value, in: Francioni/Schwartz, Equity Markets in Transition, 15 – 69, 62.

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the US, a securities exchange is classified as a national securities exchange if it has registered with the SEC under Section 6 of the Securities Exchange Act of 1934. Accordingly, the registration requires that the exchange has a set of rules ensuring that it complies with the law. Under Section 6(1)(c) an exchange can deny membership under certain circumstances – there is no general obligation to contract. In the EU, the establishment of public exchanges, i. e. RMs, is governed by the laws of the individual Member States. MiFID II, however, contains some provisions harmonizing the authorization, operation and duties of RMs.⁴³ In Germany, for example, the exchanges have to get authorization to operate by the exchange supervisory authority which requires, inter alia, a business plan and a set of rules to ensure properly trading.⁴⁴ Exchanges are classified as public legal entities, however, the legal relationship between the exchanges and their members is governed by private law, a consequence of the dualism in the German regulatory system regarding public exchanges.⁴⁵ The German securities law provides an obligation for the public exchanges to contract with market participants.⁴⁶ Due to the implementation of MiFID I and MiFID II/MiFIR, the German law also requires exchanges to provide pre-trade transparency and posttrade transparency.⁴⁷ One of the main functions of the public exchanges is the price discovery process.⁴⁸ “Price discovery is at the heart of what an exchange does, and it requires that the market be fully transparent, monitored, and surveyed so as to cre-

 Cf. Title III, Art. 44 et seqq. of MiFID II.  § 4(1) BoersG (German Stock Exchange Act); Hammen, Boersen und multilaterale Handelssysteme im Wettbewerb (Exchanges and Multilateral Trading Systems in Competition), 57.  § 2(1) BoersG; Hammen, Boersen und multilaterale Handelssysteme im Wettbewerb (Exchanges and Multilateral Trading Systems in Competition), 60; Seiffert, Boersen und andere Handelssysteme (Stock Exchanges and Other Trading Systems), in: Kuempel/Wittig, Bank- und Kapitalmarktrecht (Banking and Capital Markets Law), 4.1– 4.481, 4.98, 4.103.  Seiffert, Boersen und andere Handelssysteme (Stock Exchanges and Other Trading Systems), in: Kuempel/Wittig, Bank- und Kapitalmarktrecht (Banking and Capital Markets Law), 4.1– 4.481, 4.105.  Former §§ 30, 31 BoersG based on Art. 44, 45 MiFID I. Since January 1, 2018 the provisions in Art. 3, 6 and 8, 10 MiFIR are directly applicable.  Hammen, Boersen und multilaterale Handelssysteme im Wettbewerb (Exchanges and Multilateral Trading Systems in Competition), 103; Seiffert, Boersen und andere Handelssysteme (Stock Exchanges and Other Trading Systems), in: Kuempel/Wittig, Bank- und Kapitalmarktrecht (Banking and Capital Markets Law), 4.1– 4.481, 4.107; see Ch. 2 (B.I.2.) for further details about the price discovery process.

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ate trust.”⁴⁹ Since investors rely on the quality of the price discovery, exchanges have a great responsibility. Moreover, the prices are of macroeconomic importance and thus, regulators are interested in facilitating the execution of trades on the public exchanges where they can supervise the price discovery process and interfere if necessary.⁵⁰

b. Alternative Trading Systems However, markets have become increasingly fragmented⁵¹ and there are many alternatives to the traditional stock exchange. These venues are generally referred to as ‘alternative trading systems’ (ATSs). There is a wide range of various types of ATSs and they all differ in regard to their operation.⁵² ATSs can broadly be defined as any organization, association or person that constitutes, maintains, or provides a market place or facilities for bringing together multiple buyers and sellers, and that executes trades by matching orders according to established, non-discretionary methods.⁵³ Their common and main characteristic which distinguishes them from the registered securities exchanges or RMs is that they eliminate any third-party intermediary between the potential buyers and sellers.⁵⁴ Unlike public exchanges, ATSs operate only in the secondary market and do not provide for initial public offerings. Generally, in a typical ATS, an investor first places a limit order, indicating the price and the quantity of the security

 Francioni, An Exchange and Its Value, in: Francioni/Schwartz, Equity Markets in Transition, 15 – 69, 34.  Hammen, Boersen und multilaterale Handelssysteme im Wettbewerb (Exchanges and Multilateral Trading Systems in Competition), 103.  In a neutral sense the term ‘fragmentation’ describes the dispersal of volume among different venues. SEC Division of Trading and Markets, Equity Market Structure Literature Review – Part I: Market Fragmentation (Oct. 7, 2013), 8. See Ch. 2 (B.II.1.) for further details on market fragmentation.  Coffee/Sale/Henderson, Securities Regulation, 41, giving examples for different types of ATSs such as: bulletin board systems, crossing systems, algorithmic trading systems, passive systems executing at midpoint of another exchange’s prices and systems which use actual price discovery. See for more detailed description of the different types: Coffee/Sale/Henderson, Securities Regulation, 647.  Cf. 17 C.F.R. § 242.300(a); Shorter/Miller, Dark Pools in Equity Trading: Policy Concerns and Recent Developments (Sept. 26, 2014), 1; Seiffert, § 31 f, in: Hirte/Moellers/Altenhain, Koelner Kommentar zum Wertpapierhandelsgesetz (WpHG) (Commentary on the German Securities Trading Act), 1– 44, 18. A more detailed discussion of the definition across several countries is provided by Collins, 33 Law & Pol’y Int’l Bus. (2002), 481– 506, 485 – 487.  Choi/Pritchard, Securities Regulation, 15; Coffee/Sale/Henderson, Securities Regulation, 674.

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in which the investor wishes to transact, and the ATS will then match the order with another investor’s order, executing the trade on a customer-to-customer level.⁵⁵ ATSs typically post orders for customers to view and automatically submit matching orders for anonymous and immediate execution.⁵⁶ In regard to the distinction between lit and dark markets, ATSs can be subdivided in ‘electronic communication networks’ (ECNs)⁵⁷ and ‘dark pools’.⁵⁸ ECNs are electronic systems that automatically send their best-priced buy and sell orders to the consolidated quotation system to be included in the NBBO.⁵⁹ In contrast, dark pools do not provide their best-priced orders for inclusion in the consolidated quotation data.⁶⁰ Examples of ECNs are Instinet, Bloomberg Tradebook, and NYSE Arca. The equivalent term in the EU regulations is ‘multilateral trading facility’ (MTF) which is defined as “a multilateral system, operated by an investment firm or a market operator, which brings together multiple third-party buying and selling interests in financial instruments – in the system and in accordance with non-discretionary rules – in a way that results in a contract”⁶¹. Examples are Chi-X Europe (part of BATS Global Markets, operating as MTF until 2013), Turquoise (part of LSE Group) and Euronext Block (replacing Euronext SmartPool since July 31, 2017). In the EU, the implementation of MiFID I was a first step towards the goal to create competition on a level playing field among different venues in the same market, recognizing “the emergence of a new generation of organized trading systems alongside regulated markets”.⁶² Therefore, the rules regarding the authorization, organization and operation of MTFs are similar to those applying to RMs. They are aimed at providing fair access, equal treatment of the members,

 Choi/Pritchard, Securities Regulation, 15; Barclay/Hendershott/McCormick, 58 J. Finance (2003), 2637, 2638; SEC, ECNs/Alternative Trading Systems, https://www.sec.gov/divisions/mar ketreg/mrecn.shtml (last visited Sept. 25, 2018). See also 17 C.F.R. § 242.600(b)(23) (Rule 11Ac1– 1(a)(8)).  Barclay/Hendershott/McCormick, 58 J. Finance (2003), 2637, 2638.  The term ‘ECN’ is used in the regulatory framework of the US (see 17 C.F.R. § 242.600(b)(23), § 242.600(b)(5)).  Shorter/Miller, Dark Pools in Equity Trading: Policy Concerns and Recent Developments (Sept. 26, 2014), 1.  Coffee/Sale/Henderson, Securities Regulation, 40.  See in the following section A.III.2.  Art. 4(1)(22) MiFID II, previously Art. 4(1)(15) MiFID.  Rec. 5 MiFID; Seiffert, § 31 f, in: Hirte/Moellers/Altenhain, Koelner Kommentar zum Wertpapierhandelsgesetz (WpHG) (Commentary on the German Securities Trading Act), 1– 44, 9; Fuchs, § 31 f, in: Fuchs, Wertpapierhandelsgesetz (WpHG) Kommentar (Commentary on the German Securities Trading Act), 1– 20, 2.

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and transparent operation.⁶³ Contrary to the dualistic structure applying to regulated markets, the organization and operation of MTFs in Germany is based solely on private law.⁶⁴ Therefore, MTFs can manage the admission of financial instruments through a private contract with the issuer.⁶⁵ They have no obligation to contract, hence, customers cannot claim to get access.⁶⁶ Unlike the provisions regarding the execution of trades on RMs, the rules applying to MTFs require that the sales contract for the purchase of securities must be concluded within the MTF.⁶⁷ ECNs are considered to be ‘lit’ venues because, similar to exchanges, they publicly display their best orders in the consolidated tape and allow their stock trade offers to be accessed by investors.⁶⁸ The same applies to MTFs which have to comply with pre-trade transparency and post-trade transparency rules under the new MiFID II/MiFIR regime similar to the requirements that were already placed on RMs under MiFID I.⁶⁹ Thus, ECNs and MTFs contribute to the price discovery process. However, they do not always provide their own price formation but often refer to prices from the public exchanges. In the EU, this is even allowed as long as the prices reflect the prevailing market conditions.⁷⁰ Although RMs and MTFs have similar functions, they were not treated equally on a regulatory level under MiFID I which therefore had caused a competitive imbalance be-

 Cf. the former Art. 14 MiFID I. The new provisions are set forth in Title II of MiFID II, in particular in Art. 16 and 18 MiFID II.  Seiffert, Boersen und andere Handelssysteme (Stock Exchanges and Other Trading Systems), in: Kuempel/Wittig, Bank- und Kapitalmarktrecht (Banking and Capital Markets Law), 4.1– 4.481, 4.113.  Hammen, Boersen und multilaterale Handelssysteme im Wettbewerb (Exchanges and Multilateral Trading Systems in Competition), 84; Fuchs, § 31 f, in: Fuchs, Wertpapierhandelsgesetz (WpHG) Kommentar (Commentary on the German Securities Trading Act), 1– 20, 12; Seiffert, § 31 f, in: Hirte/Moellers/Altenhain, Koelner Kommentar zum Wertpapierhandelsgesetz (WpHG) (Commentary on the German Securities Trading Act), 1– 44, 13, 16.  Seiffert, § 31 f, in: Hirte/Moellers/Altenhain, Koelner Kommentar zum Wertpapierhandelsgesetz (WpHG) (Commentary on the German Securities Trading Act), 1– 44, 24; Fuchs, § 31 f, in: Fuchs, Wertpapierhandelsgesetz (WpHG) Kommentar (Commentary on the German Securities Trading Act), 1– 20, 4b.  Seiffert, § 31 f, in: Hirte/Moellers/Altenhain, Koelner Kommentar zum Wertpapierhandelsgesetz (WpHG) (Commentary on the German Securities Trading Act), 1– 44, 10, 17.  Coffee/Sale/Henderson, Securities Regulation, 40; Shorter/Miller, Dark Pools in Equity Trading: Policy Concerns and Recent Developments (Sept. 26, 2014), 2.  Cf. Art. 3, 6 and 8, 10 MiFIR.  Cf. Art. 4(1)(a), (2) MiFIR.

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tween RMs and MTFs.⁷¹ One major goal of the new MiFID II/MiFIR framework was to overcome this regulatory arbitrage and create a level playing field among regulated trading venues, in particular, by aligning the regulations in respect of their similarities.⁷² Because ECNs/MTFs do not have to comply with specific rules regarding the admission of securities, they can save costs and, therefore, usually do not require fees to use their services.⁷³ As they offer lower fees, faster trade execution, and rebates for providing liquidity, ECNs/MTFs can be more attractive than traditional exchanges.⁷⁴

III. Categories of Dark Trading The term ‘dark trading’ is very broad and can include (1) dark orders, i. e. reserve or non-transparent order types, also referred to as hidden orders, on lit markets that interact with lit order flow, (2) trading in so called dark pools, a type of ATS, and (3) broker-dealer internalization (internalization of order flow by brokers acting as principals).⁷⁵ The last two forms of dark trading are categorized as off-exchange trading.⁷⁶

1. Dark Orders First, dark trading can occur in form of dark orders entered on an otherwise transparent trading venue (public exchange or ECN/MTF).⁷⁷ The term ‘dark order’ usually refers to an “electronic order that can be automatically executed and for which there is no pre-trade transparency”.⁷⁸ Basically, they are orders re-

 Hammen, Boersen und multilaterale Handelssysteme im Wettbewerb (Exchanges and Multilateral Trading Systems in Competition), 97– 98.  Cf. Rec. 125 MiFID II, Rec. 25 MiFIR. See also Jacobs/Beker, Recasting of MiFID: Overview of the Provisions of the new Markets in Financial Instruments Directive and Regulation, BaFin (Aug. 15, 2014), https://www.bafin.de/dok/7874372 (last visited Sept. 25, 2018).  Hammen, Boersen und multilaterale Handelssysteme im Wettbewerb (Exchanges and Multilateral Trading Systems in Competition), 84– 85.  Zyskind, 91 Chicago-Kent L. Rev. (2016), 411, 414.  Foley/Putniņš J. Fin. Econ. (2016), 1, 4; Degryse/de Jong/van Kervel, 19 RF (2015), 1587, 1593.  See for more details of the categorization of off-exchange trading in Preece/Rosov, 70 FAJ (2014), 33, 33.  IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 4 note 5.  IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 4; Karmel, High-Frequency Trading, Direct Electronic Access and Dark Pools, New York Law Journal (Dec. 15, 2011),

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siding within the trading venue and/or being controlled by a broker without being visible on the open order book before execution.⁷⁹ They can exist, for example, as a hidden order, in which case no aspect of the order is displayed. Sometimes also iceberg orders are considered to be dark orders because in this case only a small fraction of the relevant information is displayed.⁸⁰ Dark orders can be either executed against other dark orders or combined with the orders of the lit market during auctions.⁸¹

2. Dark Pools The second category of dark trading is the trading taking place off-exchange or over-the-counter, on so called dark pools, which fall under the broad term ATS.⁸²

a. Definition and Operation In contrast to an ECN or MTF – the other type of ATSs – a dark pool is an alternative trading system in the form of a private exchange in which traders purchase and sell assets without revealing their identities and without displaying their best-priced orders for inclusion in the public consolidated quotation data.⁸³ According to a more thorough analysis of a dark pool’s main characteristics, a dark pool is any structure or participant or any electronic platform partly or solely involved in housing anonymous, non-displayed trading liquidity, which is, in other words, order flow submitted confidentially that does not appear on public order books, and which is available to be sold or bought through the submission of an order.⁸⁴ Dark pools started off by attracting investors who sought to execute large trading interests in a manner that would minimize the movement

https://www.brooklaw.edu/newsandevents/news/2012/~/media/ 507015B01660487D95CA341F93376E38.ashx (last visited Sept. 25, 2018).  O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 97; Degryse/de Jong/van Kervel, 19 RF (2015), 1587, 1593.  O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 97; Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.18.  Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.18.  See above in section A.II.2.  SEC, Concept Release on Equity Market Structure, Proposed Rule, Release No. 61358 (Jan. 14, 2010), 75 Fed. Reg. (Jan. 21, 2010), 3594– 3614, 3599; Mercurio, 33 Rev. Banking & Fin. L. (2013 – 2014), 69 – 77, 69; Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 569.  O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 96; cf. Mills, The Rise of the Dark Side; Dark pool trading and the two-tiered implication (June 2014), 10.

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of prices against the trading interest, and thereby reduce trading costs.⁸⁵ However, today, most dark pools execute trades with small sizes that are comparable to the average size of trades executed in the lit venues.⁸⁶ Fundamentally, trades in the dark sector are executed similarly to those in the lit sector.⁸⁷ The most common and simplest type of dark pools is the so-called crossing network.⁸⁸ In the quintessential example of a dark pool arrangement, a trader submits an order, for instance a ‘mid-point’ limit buy or sell order which, according to the terms, will be executed against the next marketable order with the opposite interest to arrive at the pool and will do so at a price equal to the mid-point between the best publicly reported bid and offer at the time of execution.⁸⁹ Consequently, the prices will be based on those provided by the lit markets. However, as will be presented in the next section, there is a great variety of dark pools differing not only by their type of operator but also by their function and operating mechanism which makes it impossible to provide one general example of how dark pools operate contrary to lit venues. Referring to the key characteristics of dark venues in contrast to lit venues, an important commonality among dark pools is that they do not disclose incoming orders but only completed trades.⁹⁰ Hence, they do not provide pre-trade transparency but only post-trade transparency, often with a certain delay.⁹¹ In the US this means that, in practical terms, dark pools do not report their bestpriced orders for inclusion in the consolidated quotation data displayed on the trading screens.⁹² Only participants in the dark pool gain information about available volume of liquidity, trades taking place and future trading oppor SEC, Concept Release on Equity Market Structure, Proposed Rule, Release No. 61358 (Jan. 14, 2010), 75 Fed. Reg. (Jan. 21, 2010), 3594– 3614, 3599.  SEC, Concept Release on Equity Market Structure, Proposed Rule, Release No. 61358 (Jan. 14, 2010), 75 Fed. Reg. (Jan. 21, 2010), 3594– 3614, 3599; Nimalendran/Ray, 17 J. Fin. Markets (2014), 230, 235.  Mills, The Rise of the Dark Side; Dark pool trading and the two-tiered implication (June 2014), 12.  Mills, The Rise of the Dark Side; Dark pool trading and the two-tiered implication (June 2014), 11.  Fox, MiFID II and Equity Trading: A US View, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 18.01– 18.127, 18.96.  Coffee/Sale/Henderson, Securities Regulation, 42; Ganchev/Nevmyvaka/Kearns/Vaughan, 53 Commun. ACM (2010), 99, 99.  See e. g. in the EU, Art. 7 and 11 MiFIR allow for a delayed data publication. In the US, FINRA publishes trading data for certain ATSs and OTC trading on a two-week delayed basis. See more details in Ch. 3 (B.II., C.II.3.d.).  Coffee/Sale/Henderson, Securities Regulation, 42.

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tunities.⁹³ This may lead to informational asymmetries between traders participating in a dark pool and the general public. Further, most dark pools typically match orders at prices such as the midpoint of the NBBO or the volume-weighted average price (VWAP)⁹⁴ which are both determined by pricing information derived from lit venues.⁹⁵ In the EU, by contrast to the US, there is no single consolidated quotation system and thus, dark pool operators basically had two options to determine which venues to use to calculate the reference price: first, they can rely on a single venue, usually the ‘primary’ market, i. e. major the public exchanges of the Member States, or second, they can consider other lit venues, including MTFs.⁹⁶ Under the first option, dark pools use the primary best bid and offer (PBBO) prices available on the public exchanges, under the second option, operators construct what is known as ‘the European Best Bid and Offer’ (EBBO), which includes orders from the other venues.⁹⁷ Next, dark pools can choose whether to match prices at the midpoint or at the best bid and the best ask prices.⁹⁸ The new regulations under MiFID II/MiFIR, however, prohibit using the EBBO to determine the reference price and prohibit non-price-improving trades, eliminating the possibility to execute at the best bid or the best ask price.⁹⁹ By taking lit venue prices as given, dark pools do not provide, at least direct price discovery or contribute to the price discovery process performed by the lit venues.¹⁰⁰

 Mills, The Rise of the Dark Side; Dark pool trading and the two-tiered implication (June 2014), 14.  The VWAP is a ratio generally used by institutional investors and mutual funds to make buys and sells so as not to disturb the market prices with large orders. It is the average share price of a stock weighted against its trading volume within a particular time frame, generally one day. Investopedia, Volume-Weighted Average Price, available at https://www.investopedia.com/terms/v/ vwap.asp (last visited Sept. 25, 2018). See for details of the measurement Berkowitz/Logue/Noser, 43 J. Finance (1988), 97, 102 et seqq.  Zhu, 27 RFS (2014), 747, 753.  Financial Conduct Authority, Asymmetries in Dark Pool References Prices (Sept. 2016), 2, 9.  Financial Conduct Authority, Asymmetries in Dark Pool References Prices (Sept. 2016), 9; Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.53.  Financial Conduct Authority, Asymmetries in Dark Pool References Prices (Sept. 2016), 9.  Financial Conduct Authority, Asymmetries in Dark Pool References Prices (Sept. 2016), 9. See the definition of the ‘reference price’ in Art. 4(2) MiFIR. Accordingly, the reference price is restricted to either the midpoint within the current bid and offer prices of the regulated market where the financial instrument was first admitted to trading or the most relevant market in terms of liquidity, or the opening or closing price of the relevant trading session if the trading occurs outside the continuous trading phase.  Zhu, 27 RFS (2014), 747, 753.

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The next part provides an overview of the different types of dark pools roughly categorized as useful for the further assessment of their impact on the market.

b. Types of Dark Pools The term ‘dark pool’ is used as a general term referring to a great variety of different types of dark trading venues.¹⁰¹ Not all of them operate in the same way.¹⁰² According to the Consultation Report on Issues Raised by Dark Liquidity by the Technical Committee of the International Organization of Securities Commission (IOSCO), “[d]ark pools can be differentiated based upon a number of characteristics, including access rights, the structure of dark pools, the types of orders that may be permitted, how orders are entered, and how prices are referenced and executed”.¹⁰³ For the purpose of this study, however, it is neither necessary nor useful to list the complete variety of different dark pools. Rather, it is sufficient to focus on a few characteristics that are relevant in order to assess the issues raised in regard to dark trading and dark pools in particular. Hence, differences between dark pool types are specified according to the following factors: (i.) operator type, (ii.) operation, especially order execution and price determination, and (iii.) access.

i. Operator Type One way to differentiate the different types of dark pools is to classify them according to the operator type.¹⁰⁴ This distinction is useful as it provides information about part of the participants and their interests involved in dark trading. Operator types are (1) broker-dealer, (2) exchange or other lit venue, and (3) electronic market maker or independent securities operator.¹⁰⁵

 Zaza, 18 Stan. J.L. Bus. & Fin. (2013), 319, 324; Eng/Frank/Lyn, 12 J. Int’l Bus. & L. (2014), 39, 44.  Eng/Frank/Lyn, 12 J. Int’l Bus. & L. (2014), 39, 44.  IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 11.  Preece/Rosov, 70 FAJ (2014), 33; Preece/Rosov, 70 FAJ (2014), 33, 34; see overview in Shorter/ Miller, Dark Pools in Equity Trading: Policy Concerns and Recent Developments (Sept. 26, 2014), 2– 3.  Cf. Financial Conduct Authority, Asymmetries in Dark Pool References Prices (Sept. 2016), 9 – 10; Shorter/Miller, Dark Pools in Equity Trading: Policy Concerns and Recent Developments (Sept. 26, 2014), 3 – 4; Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.16 et seqq.

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(1) Broker-Dealer Operated The most common dark pools are broker-dealer owned, also referred to as overthe-counter (OTC) dark pools. They are created by large broker-dealers, usually investment banks, for their clients and for the benefit of their own proprietary traders.¹⁰⁶ The dark pools allow the broker-dealers to better match customer orders internally and therefore save trading fees that would otherwise have to be paid to the exchanges.¹⁰⁷ Examples include Goldman Sachs’s Sigma X, Credit Suisse’s Cross Finder, Morgan Stanley’s MS Pool, UBS PIN, and Deutsche Bank Automated Trading System.

(2) Agency Broker or Exchange/Lit Venue Operated Agency broker dark pools include venues such as Liquidnet and ITG Posit, dark pools operated by exchanges or alternative trading venues include London Stock Exchange’s Baikal Global ¹⁰⁸, SmartPool of Euronext¹⁰⁹, SIX Swiss Exchange’s SIX Liquidnet Service, Xetra Midpoint of Deutsche Boerse and BATS Europe Dark Pool. They act as agents, not as principals and their trades are based on the security prices derived from the exchanges.¹¹⁰

(3) Electronic Market Maker Operated Electronic market maker dark pools are affiliated with independent securities operators who act as principals for their own accounts and accept or reject customer orders, usually at high speed.¹¹¹ Examples are Getco and Knight.

ii. Operation: Order Execution and Price Determination Further, dark pools can be differentiated according to their operational characteristics. Two functions are of particular importance for the analysis of the issues

 Shorter/Miller, Dark Pools in Equity Trading: Policy Concerns and Recent Developments (Sept. 26, 2014), 7; Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.19.  Zhu, 27 RFS (2014), 747, 753.  As of February 18, 2010, Baikal Global Limited was acquired by Turquoise Services Limited.  SmartPool was shut down on July 7, 2017 and replaced by Euronext Block (an MTF) which will start operating on July 31, 2017.  Shorter/Miller, Dark Pools in Equity Trading: Policy Concerns and Recent Developments (Sept. 26, 2014), 8.  Zhu, 27 RFS (2014), 747, 753.

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raised in regard to dark trading and the underlying purpose of this study: (1) order execution and (2) price determination. Order execution within a dark pool can be done either on a continuous basis, during a call auction, or pursuant to the negotiation by the buying and selling parties of the terms of a trade.¹¹² Mostly, orders are executed in dark pools similarly to those on the lit venues.¹¹³ Unlike the public exchanges, however, dark pools do provide little or no price discovery. Often, dark pools determine their execution prices with reference to those published in the lit sector.¹¹⁴ As previously pointed out, there may be differences between the US market and the EU market in regard to the reference price dark pools are allowed to use. Broker-dealer operated dark pools, for instance, usually derive their prices from the broker-dealer’s order flow, whereas dark pools operated by exchanges or lit venues refer to the prices from the lit sector.¹¹⁵

iii. Access The differentiation regarding the access rights is relevant as most regulations provide a “fair access rule” for alternative and dark venues. Differences in regard to access to dark pools depend on the operator and structure of the dark pool. Dark pools may provide access to clients of the participant only, to institutional investors only, to large broker-dealers only, to ATSs, MTFs and exchanges, or to a combination of any of the above.¹¹⁶

3. Broker-Dealer Internalization/Systematic Internalization The third category of dark trading is broker-dealer internalization, another form of off-exchange trading classified as a ‘bilateral’ facility contrary to ‘multilateral’ facilities which does not require an electronic system and can take place outside

 IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 12.  Mills, The Rise of the Dark Side; Dark pool trading and the two-tiered implication (June 2014), 12.  Cf. IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 12.  Shorter/Miller, Dark Pools in Equity Trading: Policy Concerns and Recent Developments (Sept. 26, 2014), 7– 8; Zhu, 27 RFS (2014), 747, 753.  IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 11.

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an exchange or ATS.¹¹⁷ Internalizers provide alternative trading venues to the regulated markets for bilateral exchange in which the broker deals directly with the customer and executes orders that could as well be executed on a lit venue.¹¹⁸ They have long been known for making trades anonymously on the phone or ‘upstairs’ but gained popularity with the increase in technology.¹¹⁹ The broker-dealer acts either as an agent and crosses two matching orders at the mid-point (also called ‘in-house matching’), or as a principal buying from the seller and selling to a buyer for his own account.¹²⁰ A trade is said to be “internalized” when a broker-dealer receives an order from a client and executes it either against another client’s offsetting order, or by buying or selling the shares directly on his own account.¹²¹ The broker-dealer may make a profit on the spread, i. e. the difference between the ask price and the bid price.¹²² It represents a form of dark trading because the broker-dealer is not required to display quotes prior to the execution and thus, the executions reflect liquidity that is not visible on the publicly available limit orderbooks or included in the consolidated quotation data.¹²³ Further, the broker-dealer has discretion regarding the acceptance of orders and may therefore, similarly to dark pools, discriminate among the counterparties.¹²⁴ The only obligation broker-dealers usually  Cf. Mutschler, Internalisierung der Auftragsausfuehrung im Wertpapierhandel (Internalization of Order Execution in Securities Trading), 48, 53 – 54; Coffee/Sale/Henderson, Securities Regulation, 42.  Di Febo/Angelini, 26 Curr. Pol. & Econ. Eur. (2015), 267, 269 – 270.  Zaza, 18 Stan. J.L. Bus. & Fin. (2013), 319, 324 note 40.  Coffee/Sale/Henderson, Securities Regulation, 42; Ferrarini/Recine, The MiFID and Internalisation, in: Ferrarini/Wymeersch, Investor Protection in Europe, 235, 236, 236; cf. Fox, MiFID II and Equity Trading: A US View, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 18.01– 18.127, 18.95; Davies/Dufour/Scott-Quinn, The MiFID: Competition in a New European Equity Market Regulatory Structure, in: Ferrarini/Wymeersch, Investor Protection in Europe, 163, 166; Biedermann, 1 Public Finance Quarterly (2015), 78, 79; Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 7.  Korsmo, 48 U. Rich. L. Rev. (2014), 523 – 609, 535.  Biedermann, 1 Public Finance Quarterly (2015), 78, 79; Davies/Dufour/Scott-Quinn, The MiFID: Competition in a New European Equity Market Regulatory Structure, in: Ferrarini/Wymeersch, Investor Protection in Europe, 163, 166.  SEC, Concept Release on Equity Market Structure, Proposed Rule, Release No. 61358 (Jan. 14, 2010), 75 Fed. Reg. (Jan. 21, 2010), 3594– 3614, 3599; Korsmo, 48 U. Rich. L. Rev. (2014), 523 – 609, 535; Woehrmann, Institutional Investors and Exchange Organizations, in: Francioni/Schwartz, Equity Markets in Transition, 499, 515; Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 7.  This discretion is, however, limited due to the “Best Execution” requirement according to which a broker-dealer is obligated to exercise reasonable care to execute a customer’s order in a way to obtain the most advantageous terms for the customer. See FINRA Rule 5310. As

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have is that they must execute the orders at prices no worse than the current official quotes, i. e. at the best price in the market.¹²⁵ Due to the fact that dark pools in the US are regulated as broker-dealers, largely the same regulations and provisions apply to internalizers, i. e. broker-dealers operating on a bilateral basis. There are currently more than two hundred broker-dealers operating as internalizers and/or operators of ATSs.¹²⁶ In the EU regulatory context, MiFID I introduced the term ‘systematic internalization’, a special form of internalization characterized by an organized, frequent and systematic basis on which an investment firm executes the orders in a professional and non-discretionary way. ¹²⁷ One example for systematic internalization in Germany is the so called “Price Improvement System” operated by the Deutsche Bank AG since November 2002.¹²⁸ In 2017, there were only eleven registered systematic internalizers (SIs) in Europe, with a total market share well below two per cent.¹²⁹ However, due to the changes under MiFID II/MiFIR, the amount increased tremendously after January 3, 2018 with the application of the new regime in the Member States. As of today, there are about 109 systematic internalizers registered in Europe.¹³⁰

B. The Rise of Dark Trading As laid down in section A the variety of dark trading is tremendous. Although it is difficult to obtain data about dark trading, available statistics reveal that the amount of trading in the dark has rapidly increased over the past decade.

the best execution requirement is a separate topic not specifically related to dark trading it will not be further addressed in this study.  17 C.F.R. § 242.611, the so-called “Order Protection Rule”. See also Coffee/Sale/Henderson, Securities Regulation, 43.  Cf. Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 7.  Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.50; Di Febo/Angelini, 26 Curr. Pol. & Econ. Eur. (2015), 267, 269. Cf. the definition in Art. 4(1)(7) MiFID I and Art. 4(1)(20) MiFID II.  Hammen, Boersen und multilaterale Handelssysteme im Wettbewerb (Exchanges and Multilateral Trading Systems in Competition), 11; Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.43.  Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.43.  See the complete list of SIs registered with ESMA, available at https://registers.esma.euro pa.eu/publication/searchRegister?core=esma_registers_upreg (last visited Sept. 25, 2018).

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While over ten years ago, approximately eighty percent of stock trading in the US occurred on the New York Stock Exchange (NYSE), it declined to about twenty percent in 2014, loosing most of the trades to off-exchange venues.¹³¹ In the second quarter of 2016, dark trading volume amounted for 43.1 percent of which 30 percent were traded on dark pools.¹³² In the EU, dark trading reports started in 2009 including five European dark pools.¹³³ While in 2009, trading in dark pools accounted for less than one percent of the volumes of equities trading, in 2016, the volume traded on dark pools accounted for about 8 percent of total value traded in equities.¹³⁴ However, it seems like since the implementation of MiFID II/MiFIR the amount of trading volume of non-displayed venues slightly decreased to currently around 5 percent.¹³⁵ Today, when executing orders, investors in the US can choose from several ECNs, more than forty dark pools, and round about twenty exchanges.¹³⁶ In the EU, after a dynamic entry and exit of dark pools, the number stabilized in

 Zyskind, 91 Chicago-Kent L. Rev. (2016), 411, 411– 412 note 10 referring to Garcia, This NYSE Plan Could Help Retail Investors, Market Watch (Dec. 24, 2014), https://www.marketwatch.com/ story/this-nyse-plan-could-help-retail-investors-2014-12-24 (last visited Sept. 25, 2018).  Bogard, TABB Equity Digest: Q2– 2016, Quarterly Report (Dec. 8, 2016), https://research. tabbgroup.com/report/v14– 071-tabb-equity-digest-q2– 2016 (last visited Sept. 25, 2018). The “dark volume” referred to in that analysis consists of Retail Wholesalers/Single-Dealer Platforms (SDP)/Other, Dark ATSs, and Hidden Exchange. According to the monthly dark liquidity tracker by Rosenblatt Securities Inc., Let There Be Light, available at http://rblt.com/research_analysis. aspx (last visited Sept. 25, 2018) dark pools approximately executed 15 % of US equity volume in 2017.  See the report by the FESE, European Equity Market Report, Year 2009, available at http:// www.fese.eu/statistics-market-research/european-equity-market-report (last visited Sept. 25, 2018).  Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 22, 26; Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 3.  A detailed and daily updated volume summary of European equity markets is provided by Cboe Global Markets, European Equities Market Volume Summary, available at http://markets. cboe.com/europe/equities/market_statistics/ (last visited Sept. 25, 2018).  Zyskind, 91 Chicago-Kent L. Rev. (2016), 411, 417; Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 5 – 6. The number of exchanges may vary depending on whether affiliated exchanges are taken into account as individual exchanges or only counted as one exchange. The SEC provides a list of all securities exchanges, SEC, National Securities Exchanges, available at https://www.sec.gov/fast-answers/divisionsmarke tregmrexchangesshtml.html (last visited June 8, 2018). A monthly list of all ATSs is also provided by the SEC, Alternative Trading System List, available at https://www.sec.gov/foia/docs/atslist. htm (last visited Sept. 25, 2018). However, this list does not differ between “lit” ATSs and “dark” ATSs.

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recent years and at the end of 2016, there were 15 active dark pools.¹³⁷ The current number of registered RMs is 110, the number of registered MTFs 190.¹³⁸ The following part will point out the major historical developments (I.) and other factors (II.) which were significant for the rise of dark trading and which give conclusions to why dark trading is gaining so much interest by both market participants and market regulators. It shall further provide the basis necessary to understand the different regulatory systems and the regulatory status quo as well as current discussions about new regulatory changes (as examined in Chapter 3).

I. Historical Development Although today dark trading plays a major role in the securities market almost worldwide, the development of this practice differed among countries, especially due to different regulatory steps. It is thus necessary to take a look not only at the general changes that occurred in the trading industry but also at the individual events in the major global securities markets, particularly the US and the EU, that caused these changes. Overall, the significant changes in the markets’ structure were caused by the coincidence of three main factors: (1) technology, giving rise to new electronic trading functionalities, including high-frequency trading (HFT), (2) regulation, providing the legal basis for the growth of new trading venues, and (3) globalization, creating international competition among the markets and thereby fostering the rapid changes.¹³⁹

1. Technological Changes The phenomenon of dark trading arose when technology started to change the securities market structure and the trading industry. As in other markets, computer technology was the driving factor, replacing human workers and making them dependent on it at the same time. This development of computer technology commenced in 1971 when the National Association of Securities Dealers Au-

 Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 22, 23 providing a table with the major dark pools active in Europe between 2009 and 2016.  The exact number is provided in the register by ESMA, available at https://registers.esma. europa.eu/publication/searchRegister?core=esma_registers_upreg (last visited Sept. 25, 2018).  Cf. Coffee/Sale/Henderson, Securities Regulation, 601.

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tomated Quotations (NASDAQ) was founded, which became the world’s first electronic stock market with an electronic quotation system to trade securities.¹⁴⁰ The introduction of NASDAQ prompted other stock exchanges internationally to follow this example and implement the possibility to electronically transmit orders to buy and sell securities.¹⁴¹ Program Trading followed in the 1980s, allowing computerized trading involving a number of different portfolio strategies, for example regarding trades between the equity and futures markets, such that a program could automatically put in an order when there was a pre-determined difference between the two markets.¹⁴² However, it was not until the 1990s when the price of computer systems became more affordable that market makers used the electronic trading systems not only to increase the number of trades they could handle per day but also to improve the trading experience itself by providing the opportunity to trade outside the regular exchanges.¹⁴³ ECNs were introduced and soon after, human intermediaries acting for and on behalf of investors and exchanges were replaced by computers creating a new level of trading.¹⁴⁴ Individuals could subscribe to these systems and enter orders electronically.¹⁴⁵ Since the systems were able to collect and distribute market data, investors were not dependent on middlemen any longer, but could find matching orders of other users in the same system and thereby experience better execution and lower trading costs.¹⁴⁶ As ECNs gained popularity, they undermined the exchanges’ dominance of the market.¹⁴⁷ Trading moved away from the traditional trading floors and became increasingly electronic.¹⁴⁸ Today, only a few exchanges retain their physical trading floor¹⁴⁹ while others¹⁵⁰ abandoned it completely and fully transformed into electronic markets.¹⁵¹

 Clarke, 8 LFMR (2014), 342, 343; Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 10.  Clarke, 8 LFMR (2014), 342, 343.  Clarke, 8 LFMR (2014), 342, 343; Agarwal, High Frequency Trading: Evolution and the Future (2012), 4.  Batista, 14 J. High Tech. L. (2014), 83, 88.  Zyskind, 91 Chicago-Kent L. Rev. (2016), 411, 414.  Agarwal, High Frequency Trading: Evolution and the Future (2012), 4.  Batista, 14 J. High Tech. L. (2014), 83, 88; Gadinis, 3 Va. L. & Bus. Rev. (2008), 311– 356, 318.  Zyskind, 91 Chicago-Kent L. Rev. (2016), 411, 414.  Batista, 14 J. High Tech. L. (2014), 83, 88; Gadinis, 3 Va. L. & Bus. Rev. (2008), 311– 356, 313.  The most popular example is the NYSE.  Examples include regional stock exchanges, such as the Chicago Stock Exchange and the Frankfurter Boerse.  Hazen, Treatise on the law of securities regulation: Volume 5, 197.

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a. Automated Trading and Algorithmic Trading New technologies enabled not only new trading venues but also new and improved trading techniques. In the 1980s, the increasing progress of computer technology led to the development of automated trading performed by algorithms with little or no human intervention.¹⁵² Algorithmic trading can be defined as a “computer-driven process in which an algorithm replicates decisions previously made by traders and investors in relation to the composition, timing, format, and destination of orders”.¹⁵³ In the European regulatory system it is defined as “trading in financial instruments where a computer algorithm automatically determines individual parameters of orders such as whether to initiate the order, the timing, price or quantity of the order or how to manage the order after its submission, with limited or no human intervention”.¹⁵⁴ The breadth, variety and complexity of algorithms is continuously evolving and modern algorithms are able to learn from market activity and can adjust their trading strategy of the order based on what the algorithm perceives is happening in the market.¹⁵⁵ But how does an algorithm actually work? Algorithms are regularly redesigned or decommissioned and thus are very complex.¹⁵⁶ Without getting into technical details, the basic construction of an algorithm is a set of rules or instructions which can, for example, either send portions of an order to the market at pre-set intervals to minimize market impact costs¹⁵⁷ or identify when there is a larger-than normal buyer or seller in the market by analyzing market information and data.¹⁵⁸ More complex algorithms may even entail many algorithms that are able to analyze information from multiple markets in different assets, or may

 Conac, Algorithmic Trading and High-Frequency Trading (HFT), in: Busch/Ferrarini, Regulation of the EU Financial Markets, 17.01– 17.62, 17.03 – 17.04.  Conac, Algorithmic Trading and High-Frequency Trading (HFT), in: Busch/Ferrarini, Regulation of the EU Financial Markets, 17.01– 17.62, 17.03.  Art. 4(1)(39) MiFID II. It excludes “any system that is only used for the purpose of routing orders to one or more trading venues or for the processing of orders involving no determination of any trading parameters or for the confirmation of orders or the post-trade processing of executed transactions”.  Clarke, 8 LFMR (2014), 342, 346; Chlistalla, High-frequency trading – Better than its reputation? (Feb. 7, 2011), 3; IOSCO Technical Committee, Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency (July 2011), 10.  IOSCO Technical Committee, Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency (July 2011), 10.  IOSCO Technical Committee, Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency (July 2011), 10.  Zink/Selmier, 56 Business Horizons (2013), 715, 718.

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predict the presence and actions of other algorithms.¹⁵⁹ The algorithm itself will decide, for instance, whether the timing is right to place an order, which securities are promising to trade in, what quantity will be traded and at which price.¹⁶⁰ Compared to a human trader, the algorithm can make all of these decisions at a much higher speed.

b. High-frequency Trading In order to completely understand the rapid rise of dark trading and its importance for today’s market structure, it is necessary to examine its relation to high-frequency trading. High-frequency trading (HFT) is a subcategory of algorithmic trading.¹⁶¹ It is not a new strategy but rather a “technologically more advanced method of implementing particular trading strategies” that is characterized by speed.¹⁶² Computers performing HFT are able to analyze market information at a high speed and to rapidly move into and out of trading positions in not only milliseconds but even microseconds.¹⁶³ Moreover, these advanced algorithms are able to reduce the typical delay that occurs when transmitting an order to the market, after it is submitted until it arrives and is executed, so-called latency.¹⁶⁴ As a consequence of its nature as a constantly developing mathematical method it is almost impossible to clearly define the term ‘high-frequency trading’. A unified definition of HFT does not exist and may not even be practical for regulatory purposes as it could easily become obsolete.¹⁶⁵ However, attempts have been made by the different regulators to identify characteristics often attributed to HFT.

 IOSCO Technical Committee, Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency (July 2011), 10.  Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 620.  Conac, Algorithmic Trading and High-Frequency Trading (HFT), in: Busch/Ferrarini, Regulation of the EU Financial Markets, 17.01– 17.62, 17.05; Busch, 10 LFMR (2016), 72, 74.  Chlistalla, High-frequency trading – Better than its reputation? (Feb. 7, 2011), 3.  Clarke, 8 LFMR (2014), 342, 342; Busch, 10 LFMR (2016), 72, 74; Kasiske WM (2014), 1933 – 1940, 1933.  Kasiske WM (2014), 1933 – 1940, 1933; Conac, Algorithmic Trading and High-Frequency Trading (HFT), in: Busch/Ferrarini, Regulation of the EU Financial Markets, 17.01– 17.62, 17.06; Lewis, Flash Boys, 61. For further details on latency see Francioni, An Exchange and Its Value, in: Francioni/Schwartz, Equity Markets in Transition, 15 – 69, 21.  Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 483; IOSCO Technical Committee, Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency (July 2011), 21.

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In summary, the term typically refers to (1) professional traders acting in a proprietary capacity, (2) using extraordinarily highspeed and sophisticated computer programs for initiating, generating, routing, and executing orders, (3) with little or no human intervention, (4) submitting numerous orders that are cancelled shortly after their submission, (5) establishing and liquidating positions within very short time-frames, resulting in the frequent turnover of many small positions in one or more financial instruments, (6) thereby using infrastructure intended to minimize network and other types of latencies, including the use of co-location services¹⁶⁶ and individual data feeds offered by exchanges¹⁶⁷, and (7) ending the trading day in as close to a flat positions as possible, meaning that very few or no positions are maintained overnight.¹⁶⁸ These characteristics are often attributed to HFT, however, not all of them must be present for a proprietary trading firm to be classified as high-frequency trader.¹⁶⁹ But why does speed matter? Simply, the trading business can be compared to a race. The fastest one wins the race and thus, may receive the prize. Competition leads to innovation and thus, runners come up with different kind of training strategies, new equipment, and sometimes, even illegal doping substances in order to be the fastest one and win the race. Traditionally, a trader can make money, for example, by buying a security, holding it until a buyer appears on the same trading venue willing to buy it at a higher price and then selling it keeping the price difference.¹⁷⁰ Due to deregulation of the financial markets, today, there are multiple trading venues listing the same securities, though sometimes at different prices, creating an opportunity

 Some HFT firms purchase real estate as close as possible to securities exchanges or rent racks belonging to co-location providers in order to cut down the physical distance between their trading server and the exchange server to minimize the latency in data transfer, see Agarwal, High Frequency Trading: Evolution and the Future (2012), 13.  Some HFT firms use individual data feeds provided by trading venues in order to get traderelated information before it is processed to the consolidated data feed which creates some latency until it reaches the market, see Agarwal, High Frequency Trading: Evolution and the Future (2012), 13.  Cf. Art. 4(1)(4) MiFID II; SEC, Concept Release on Equity Market Structure, Proposed Rule, Release No. 61358 (Jan. 14, 2010), 75 Fed. Reg. (Jan. 21, 2010), 3594– 3614, 3606; IOSCO Technical Committee, Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency (July 2011), 21.  SEC Division of Trading and Markets, Equity Market Structure Literature Review – Part II: High Frequency Trading (Mar. 18, 2014), 4.  Cooper/Davis/van Vliet, 26 Bus. Ethics Q. (2016), 1, 4.

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to make profit by catching the price difference.¹⁷¹ Thus, if a trader can move fast enough, it can buy a security at the lower price on one venue and selling it at the higher price on another venue.¹⁷² Since this price difference is usually only a fraction of a cent, the trader has to execute millions of trades this way in order to get a substantial return. Moreover, the trader may not be the only one performing this trading strategy but rather there are hundreds of traders pursuing the same method in order to make profit. Therefore, time advantages can make an important difference and the trader needs to be faster than the others. In the end, getting to the market first is what matters, making speed in trading so important.¹⁷³ In order to win this race, traders spend an enormous amount of money to develop sophisticated algorithms that are able to handle a large number of trades during a trading day, and that can make trading decisions faster than other algorithms – within milliseconds or less.¹⁷⁴ Further, traders invest in the best available technology, such as high-speed fiber optic cables and co-location services, to get their computers as close to the trading venues as possible and thereby reduce the latency¹⁷⁵, and pay for early access to data feeds providing them with relevant market information influencing the market development¹⁷⁶. As with competition among runners, the aim to have an informational advantage leads to competition and thus to innovation which is not problematic per se but rather desirable up to a certain extent and may improve overall market efficiency, for example by providing more liquidity.¹⁷⁷ Technology is the key to

 Cooper/Davis/van Vliet, 26 Bus. Ethics Q. (2016), 1, 4; Kasiske WM (2014), 1933 – 1940, 1933; cf. SEC, Concept Release on Equity Market Structure, Proposed Rule, Release No. 61358 (Jan. 14, 2010), 75 Fed. Reg. (Jan. 21, 2010), 3594– 3614, 3608.  Cooper/Davis/van Vliet, 26 Bus. Ethics Q. (2016), 1, 4.  Francioni/Schwartz (eds.), Equity Markets in Transition, 100.  Cf. Francioni/Schwartz (eds.), Equity Markets in Transition, 103.  Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 484; Conac, Algorithmic Trading and High-Frequency Trading (HFT), in: Busch/Ferrarini, Regulation of the EU Financial Markets, 17.01– 17.62, 17.06; Agarwal, High Frequency Trading: Evolution and the Future (2012), 12– 13, listing several factors contributing to low latency. See explanation of the term ‘latency’ above in note 164.  Coffee/Sale/Henderson, Securities Regulation, 619, providing an example showing the importance and the value of time advantages. Accordingly, traders were willing to pay up to $6,000 per month for two-second early access to the University of Michigan Consumer Survey, which was released by Thompson Reuters. The full advantage of the information was impounded into stock prices 15 milliseconds after Thompson Reuters released the information to paying subscribers.  Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 484; Clarke, 8 LFMR (2014), 342, 344.

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success – the “enabler and differentiator”.¹⁷⁸ Therefore, traders developed a number of trading strategies based on technological advancements to profit from HFT; however, as will be discussed in more detail in Chapter 2, some traders also come up with strategies that are considered to be unfair and illegal, socalled predatory trading strategies. Not all of the HFT strategies are new but the extent by which the strategies can be pursued using HFT is new.¹⁷⁹ Since there is such a variety of trading strategies constantly developing, due to technological improvements. It is almost impossible to list all of them. The following section, therefore, provides an overview of the most popular HFT strategies grouped into three broad categories – (1) market making, (2) arbitrage and (3) directional.¹⁸⁰

(1) Market Making Strategies The market making strategy enables high-frequency traders to make money on the bid-ask spread. The traders continuously place bets on both sides of the trade by placing a limit order to sell slightly above the current market price, or to buy slightly below the current market price, thereby profiting from the difference between the two.¹⁸¹ High-frequency traders use algorithms where the limit orders with these conditions are specified, so that the system can automatically enter trades when the conditions are right.¹⁸² The profitability may even be enhanced if the venue applies the maker-taker fee structure and thus, offers a rebate to the provider of liquidity, i. e. traders who buy at the bid price and sell at the ask price.¹⁸³ In order to gain the liquidity rebate fee, high-frequency traders usually look for large orders, fill part of it, and then offer these shares back to the market by placing a limit order.¹⁸⁴ Thereby, they are providing liquidity to the market and thus, are eligible to collect the rebate fee.¹⁸⁵

 Agarwal, High Frequency Trading: Evolution and the Future (2012), 12.  IOSCO Technical Committee, Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency (July 2011), 23.  Cf. overview by Agarwal, High Frequency Trading: Evolution and the Future (2012), 9 and IOSCO Technical Committee, Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency (July 2011), 23 – 24 suggesting to categorize the strategies into three groups. Further details on HFT strategies are discussed in Ch. 2 (B.IV.1.).  Agarwal, High Frequency Trading: Evolution and the Future (2012), 9; Cooper/Davis/van Vliet, 26 Bus. Ethics Q. (2016), 1, 4.  Agarwal, High Frequency Trading: Evolution and the Future (2012), 9.  IOSCO Technical Committee, Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency (July 2011), 23; Agarwal, High Frequency Trading: Evolution and the Future (2012), 9; Batista, 14 J. High Tech. L. (2014), 83, 89.  Agarwal, High Frequency Trading: Evolution and the Future (2012), 9.

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(2) Arbitrage Strategies Traders employing arbitrage strategies seek to take advantage of pricing discrepancies between related products, such as derivatives and their underlying securities, or Exchange Traded Funds (ETFs) and their underlying stocks.¹⁸⁶ Another possibility is to exploit the momentary inconsistencies in factors such as rates, prices, and other conditions between different exchanges or asset classes and to make profit by, for instance, buying a security at a certain price on one exchange and selling it at a higher price on another exchange within the gap of a few seconds during which a price differential may exist.¹⁸⁷ Although, at times, the price differences exist only for milliseconds and prices move and adjust quickly, the gap is just long enough for high-frequency traders to take advantage of it, while other traders do not even recognize the differences.¹⁸⁸

(3) Directional Strategies Another profit-making strategy is to use the speed advantage to predict market movement and to trade based on this information.¹⁸⁹ This can be done in several ways. Either, the high-frequency trader estimates expected price changes according to anticipated events by using superior technology to analyze past patterns.¹⁹⁰ Further, the trader can use the technology and speed as well as other advantages, such as privileged access to individual data feeds, to detect information about trading interest in the market sooner than other traders.¹⁹¹

 Cooper/Davis/van Vliet, 26 Bus. Ethics Q. (2016), 1, 5.  SEC, Concept Release on Equity Market Structure, Proposed Rule, Release No. 61358 (Jan. 14, 2010), 75 Fed. Reg. (Jan. 21, 2010), 3594– 3614, 3608; Adler, 39 Vt. L. Rev. (2014), 161– 205, 177.  Agarwal, High Frequency Trading: Evolution and the Future (2012), 9; Cooper/Davis/van Vliet, 26 Bus. Ethics Q. (2016), 1, 4; Adler, 39 Vt. L. Rev. (2014), 161– 205, 177.  Kasiske WM (2014), 1933 – 1940, 1933.  Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 9; Adler, 39 Vt. L. Rev. (2014), 161– 205, 175 who calls this strategy ‘wave riding’; IOSCO Technical Committee, Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency (July 2011), 24; SEC Division of Trading and Markets, Equity Market Structure Literature Review – Part II: High Frequency Trading (Mar. 18, 2014), 8.  IOSCO Technical Committee, Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency (July 2011), 24.  Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 9; IOSCO Technical Committee, Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency (July 2011), 24; Hazen, Treatise on the law of securities regulation: Volume 5, 247.

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c. Impact of HFT on the Market and the May 6th Flash Crash Due to the increasing automation, trading practices and interconnections between markets have become so complex that some market activities can hardly be understood and market participants are concerned about their impact on market efficiency and integrity.¹⁹² Researchers and regulators disagree on the effects of this impact.¹⁹³ Some suggest that HFT provides order flow increasing the liquidity level, and improves the security prices by identifying and exploiting price discrepancies between markets leading to a more frequent and accurate price update and thus, narrower spreads.¹⁹⁴ Others, however, emphasize that HFT destabilizes the order book due to the speed at which orders are entered and removed, increases the overall volatility due to the price fluctuations caused by the short holding periods, and discourages other market participants from trading by gaining constant advantages due to the superior technology, increasing costs for other investors.¹⁹⁵ Another concern is that the growing involvement of HFT and the high dependence on technology may increase the risk of trading errors and contribute to the transmission of shocks across trading venues and markets.¹⁹⁶ Several sit-

 Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 603 – 604; IOSCO Technical Committee, Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency (July 2011), 10.  Summary of economic literature assessing the positive and negative impact of HFT provided by SEC Division of Trading and Markets, Equity Market Structure Literature Review – Part II: High Frequency Trading (Mar. 18, 2014), 8 – 12; Clarke, 8 LFMR (2014), 342, 344. See for overview of different positions taken by regulators in the EU: Conac, Algorithmic Trading and High-Frequency Trading (HFT), in: Busch/Ferrarini, Regulation of the EU Financial Markets, 17.01– 17.62, 17.17.  Overview of benefits provided by Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 620 – 621; Conac, Algorithmic Trading and High-Frequency Trading (HFT), in: Busch/Ferrarini, Regulation of the EU Financial Markets, 17.01– 17.62, 17.12; Agarwal, High Frequency Trading: Evolution and the Future (2012), 10; Clarke, 8 LFMR (2014), 342, 344; Cooper/Davis/van Vliet, 26 Bus. Ethics Q. (2016), 1, 5 with further empirical references.  IOSCO Technical Committee, Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency (July 2011), 10; Conac, Algorithmic Trading and High-Frequency Trading (HFT), in: Busch/Ferrarini, Regulation of the EU Financial Markets, 17.01– 17.62, 17.13; Moloney, EU Securities and Financial Markets Regulation, 526 – 527; Agarwal, High Frequency Trading: Evolution and the Future (2012), 11.  IOSCO Technical Committee, Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency (July 2011), 10; Clarke, 8 LFMR (2014), 342, 347; Agarwal, High Frequency Trading: Evolution and the Future (2012), 16.

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uations evidenced that, for instance, faulty or improperly tested algorithms can cause severe undesired market impact.¹⁹⁷ This concern became apparent, in particular, when on May 6, 2010 the US securities market was hit by what is known as the infamous ‘Flash Crash’.¹⁹⁸ The event brought HFT “to the forefront of the attention of all market participants” and regulators worldwide.¹⁹⁹ In sum, on May 6, 2010, the prices of many US equity products experienced an extraordinarily rapid price decline causing a huge drop in the Dow Jones Industrial Average of 9.16 percent compared to the closing index the previous day within seventeen minutes, so that an artificial trading pause of five seconds was triggered, after which trading resumed, prices stabilized and the markets recovered almost as quickly as they had plummeted.²⁰⁰ Over 20,000 trades across more than 300 securities were executed at prices that deviated more than 60 percent from their earlier values they had just moments before the transaction and many of these trades were executed at prices of a penny or less, or as high as USD 100,000 before prices of those securities stabilized again.²⁰¹ By the end of the day, officials from all exchanges agreed on a uniform protocol for cancelling trades, resulting in 268 different equity securities being cancelled, and more the next day. The actual cause of the dramatic changes of the market on that day is still unknown and observers disagree on it.²⁰² However, the SEC’s report on the event on May 6, 2010 found that the acceleration of the decline was caused, particularly, by HFT strategies and aggressive selling of HFT traders.²⁰³ Moreover, the flash crash demonstrated how a shock in one market can trigger destabilizing  Agarwal, High Frequency Trading: Evolution and the Future (2012), 16.  For a detailed analysis of the events of May 6, 2010 see U.S. Commodity Futures Trading Commission/SEC, Findings Regarding the Market Events of May 6, 2010 (Sept. 30, 2010), 1– 6, 9.  Agarwal, High Frequency Trading: Evolution and the Future (2012), 18; cf. Clarke, 8 LFMR (2014), 342, 343.  U.S. Commodity Futures Trading Commission/SEC, Findings Regarding the Market Events of May 6, 2010 (Sept. 30, 2010), 1; Hazen, Treatise on the law of securities regulation: Volume 5, 245; Agarwal, High Frequency Trading: Evolution and the Future (2012), 18; IOSCO Technical Committee, Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency (July 2011), 11.  U.S. Commodity Futures Trading Commission/SEC, Findings Regarding the Market Events of May 6, 2010 (Sept. 30, 2010), 1; IOSCO Technical Committee, Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency (July 2011), 11.  Hazen, Treatise on the law of securities regulation: Volume 5, 246.  U.S. Commodity Futures Trading Commission/SEC, Findings Regarding the Market Events of May 6, 2010 (Sept. 30, 2010), 3, 6 – 7; U.S. Commodity Futures Trading Commission/SEC, Findings Regarding the Market Events of May 6, 2010 (Sept. 30, 2010), 12, 14, 47– 48; Agarwal, High Frequency Trading: Evolution and the Future (2012), 18.

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effects in other related markets if they are strongly interconnected, threatening market efficiency and integrity.²⁰⁴ Although occasional trading errors and episodic volatility spikes are not a mystery and have happened before, the speed, automation and interconnectedness of the markets amplified by algorithms allowed the shock to pass rapidly, thereby increasing the development of a systemic crisis.²⁰⁵

d. Relation between High-frequency Trading and Dark Trading The expansion and increasing occurrence of HFT as such do not explain how HFT is related to the rise of dark trading. Consider again the race metaphor: Some runners, because they can afford the better equipment and more professional training, are always faster than others. Nothing unusual and why should they not gain advantages if they can afford it? As long as these methods are fair, they create incentives and make the competition more competitive, presumably leading to an overall improvement of the quality of the running performance and the race. Of course, this does not apply if the methods are unfair and therefore, in most circumstances, prohibited or considered to be illegal, such as doping. But even if the all runners do only use fair and legal methods, it might seem to be unfair if the world’s best runners compete with runners in the local league. That is why there are different leagues and different levels of races. In regard to high-frequency trading, some traders invest large sums of money in technology, the development of sophisticated algorithms and advanced equipment in order to lower latency and to trade faster.²⁰⁶ However, other participants, i. e. retail investors trading through broker-dealers or institutional investors, may not be able to afford the same advancements. Moreover, they cannot hide part of the volume or order anymore as high-frequency traders use specific algorithms to detect hidden orders and volumes.²⁰⁷ Since on a typical exchange they all compete with each other, high-frequency traders may always beat the other market participants. This can result in higher trading costs

 U.S. Commodity Futures Trading Commission/SEC, Findings Regarding the Market Events of May 6, 2010 (Sept. 30, 2010), 6; IOSCO Technical Committee, Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency (July 2011), 10 – 11.  Clarke, 8 LFMR (2014), 342, 347; IOSCO Technical Committee, Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency (July 2011), 10 – 11.  Agarwal, High Frequency Trading: Evolution and the Future (2012), 17.  Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 10 – 11. See also the findings in Supreme Court, New York County, New York, People ex rel. Schneiderman v. Barclays Capital Inc. (Feb. 13, 2015) 47 Misc.3d 862, *865, *870.

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for other investors.²⁰⁸ Although this kind of advantage is not unfair per se, some consider it to create a risk for the overall fairness and integrity of the markets.²⁰⁹ HFT may unduly distort market conditions and undermine equal trading opportunity among the market participants, resulting in an erosion of investor confidence and, eventually, in a reluctance to participate in the market.²¹⁰ Even though these allegations are not entirely proven to be true, there is no doubt that some HFT practices, the already mentioned predatory trading strategies, cause actually unfair implications and are therefore prohibited.²¹¹ As the share of trades involving HFT increased²¹² the demand of other investors to hide from high-frequency traders grew.²¹³ And what better place is there to hide than in the dark? Broker-dealers as well as exchanges invented their own dark pools and offered a trading platform presumably free of high-frequency traders as often promoted²¹⁴ by providing restricted access and prohibiting high-frequency traders to enter the pool. However, since it was recently revealed that high-frequency traders, in breach of the terms promised by the operators, had been granted access to

 Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 10; Zyskind, 91 Chicago-Kent L. Rev. (2016), 411, 416. A practical example is provided by Lewis, Flash Boys, 31– 34.  Agarwal, High Frequency Trading: Evolution and the Future (2012), 17.  Agarwal, High Frequency Trading: Evolution and the Future (2012), 17; Kasiske WM (2014), 1933 – 1940, 1933 – 1934.  See for a detailed description and classification of HFT practices Serbera/Paumard, 36 RIBAF (2016), 271 et seqq.; Kasiske WM (2014), 1933 – 1940, 1935; Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 494; Teigelack, Market Manipulation, in: Veil, European Capital Markets Law, 225, 235 – 237, 243. A further analysis of the regulatory restrictions is provided in Ch. 2 (B.IV.) and Ch. 3 (C.II.3.g.).  Today, HFT trades in Europe amount around one-third, see Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 9; in the US, HFT trades amount around 40 – 70 percent, see Hazen, Treatise on the law of securities regulation: Volume 5, 246.  Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 9.  Supreme Court, New York County, New York, People ex rel. Schneiderman v. Barclays Capital Inc. (Feb. 13, 2015) 47 Misc.3d 862, *865, *870; SEC, In the Matter of Pipeline Trading Systems LLC, Exchange Act Release No. 65,609, 2011 WL 5039038 (Oct. 24, 2011) Release No. 9271, *6; SEC, In the Matter of ITG Inc. and AlterNet Securities, Inc., File No. 3 – 16742 (Aug. 12, 2015), para. 4. See also Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 333; Woehrmann, Institutional Investors and Exchange Organizations, in: Francioni/Schwartz, Equity Markets in Transition, 499, 515.

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some dark pools²¹⁵ and in addition engaged in some of the predatory trading strategies, HFT has raised new issues in regard to dark trading.²¹⁶

2. Regulatory Changes Along with the technological development, many jurisdictions implemented regulatory changes. Together, these regulations and new technologies led to a transformation from an exchange-dominated market to a fragmented market where today an increasing amount of securities is traded on other venues, being referred to as off-exchange trading.²¹⁷ Although, overall, the global markets have undergone almost the same changes due to similar events and regulatory steps, some differences in the development of the markets exist which underlie the diverse approaches taken by the regulators. The following part briefly summarizes the significant events and regulatory changes in the major global markets, namely of (a) the US, and (b) the EU in chronological order, whereas Chapter 3 will take a closer look at the individual regulations and their impact on the market structure.

a. US Market In the US, there are three regulatory changes, in particular, which led to a rapid increase in dark trading: (1) The 1975 Act Amendments to the Securities Exchange Act of 1934, (2) The Order Handling Rules from 1996, (3) Regulation ATS from 1998, and (4) Regulation NMS from 2005. The first revolutionary step was taken in 1975 with the amendments to the Securities Exchange Act of 1934 (1975 Act Amendments)²¹⁸ which were designed to increase competition in the securities markets and set up the “framework in which competing markets would be linked together in ways that would produce the best prices and efficient executions”.²¹⁹ The main aim was to facilitate the  Referred to as ‘sharks in dark pools’ by Clarke, 8 LFMR (2014), 342, 348.  Supreme Court, New York County, New York, People ex rel. Schneiderman v. Barclays Capital Inc. (Feb. 13, 2015) 47 Misc.3d 862, *865, *870; SEC, In the Matter of Pipeline Trading Systems LLC, Exchange Act Release No. 65,609, 2011 WL 5039038 (Oct. 24, 2011) Release No. 9271, *6; SEC, In the Matter of ITG Inc. and AlterNet Securities, Inc., File No. 3 – 16742 (Aug. 12, 2015), para. 4. See Ch. 2 (B.IV.1.) for further details on HFT strategies as a concern raised in regard to dark trading.  Zyskind, 91 Chicago-Kent L. Rev. (2016), 411, 413.  Congress, Pub. L. 94– 29, 89 Stat. 97 (June 4, 1975); § 11 A(1)(C) SEA, 15 U.S.C. § 78a et seqq.  Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 573; Gillis, 31 FAJ (1975), 12, 12; for more details see Macey/O’Hara, 28 J. Legal Stud. (1999), 17, 28 – 35.

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development of a National Market System (NMS) for equity securities traded within the US by linking all trading venues through communication and data processing facilities to actually prevent the market from fragmentation.²²⁰ It therefore implemented the consolidated quote and tape system for the distribution of all best bids and offers from each national securities exchange.²²¹ This system selects the quote with the highest-priced bid/lowest-priced offer and broadcasts it as the so called National Best Bid and Offer (NBBO).²²² Moreover, the 1975 Act Amendments amended Section 6(e) of the Securities Exchange Act of 1934 which required that orders had to be transmitted to an exchange for execution, thereby prohibiting off-exchange trading of listed securities.²²³ With the adoption of Rule 19c-1 in 1975, and the even stricter Rule 19c-3 in 1980, the SEC limited the off-exchange trading restrictions imposed by public exchange rules, including the NYSE Rule 390, and thus opened the market for offexchange trading venues.²²⁴ The rapid growth of ECNs was further directly attributable to another policy change.²²⁵ In 1997, the SEC adopted new ‘Order Handling Rules’ which required exchange specialists and OTC market makers to publicly display customer limit orders or to include them in their own quotes when the orders were better than the quotes offered by the specialist or market maker.²²⁶ In the ECNs traders could

 Cf. Macey/O’Hara, 28 J. Legal Stud. (1999), 17, 31– 32; Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 12; Gillis, 31 FAJ (1975), 12, 12; Palmer, Dark and Lit Markets: A User’s Guide, Institutional Investor Journals (2010), www.iinews.com/ site/pdfs/liquidityii_flextrade.pdf (last visited Sept. 25, 2018).  Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 13 – 14; Palmer, Dark and Lit Markets: A User’s Guide, Institutional Investor Journals (2010), www.iinews.com/site/pdfs/liquidityii_flextrade.pdf (last visited Sept. 25, 2018).  See 17 C.F.R. § 242.600(b)(42).  Karmel, High-Frequency Trading, Direct Electronic Access and Dark Pools, New York Law Journal (Dec. 15, 2011), https://www.brooklaw.edu/newsandevents/news/2012/~/media/507015B 01660487D95CA341F93376E38.ashx (last visited Sept. 25, 2018).  The NYSE Rule 390 basically required that any NYSE member firm’s trades as principal in listed stocks take place on the exchange, stood in the way of complete integration. Rule 19c-3 made NYSE Rule 390 inapplicable to any stock listed after April 26, 1979. However, it was not until 2000 that the NYSE, under the pressure of the SEC, eliminated Rule 390, since there were no longer reasonable arguments for its existence. See Coffee/Sale/Henderson, Securities Regulation, 633 and Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 15.  Coffee/Sale/Henderson, Securities Regulation, 604– 605.  Brummer, 84 Fordham L. Rev. (2015), 977– 1052, 1006; Coffee/Sale/Henderson, Securities Regulation, 604– 605; Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 16 – 17.

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still trade at better prices and were not obliged to immediately publish an improved quote but only after the trade was completed, which allowed ECNs to directly compete with other venues for the best prices and order flow.²²⁷ In 1998, Regulation Alternative Trading System (Regulation ATS)²²⁸ was adopted which governs the regulation of off-exchange markets and enables alternative trading systems to enter the market that, until then, had been dominated by exchanges.²²⁹ Under Regulation ATS, alternative trading systems, including dark pools, must register as broker-dealers, however not necessarily as exchanges.²³⁰ Notably, this allowed ATSs to avoid certain requirements applicable only to exchanges resulting in a much lighter regulatory framework for ATSs.²³¹ Regulation ATS contains two important rules, the ‘quote rule’ and a ‘fair access rule’. The ‘quote rule’ requires ATSs that exceed five percent of the average daily trading volume of a single security to submit their best bids and offers to a trade reporting facility or an exchange to be included in the NBBO.²³² Exemptions from the quote rule are provided to venues, such as dark pools, that do not provide information about their orders to any participant regardless of the volume they execute.²³³ According to the ‘fair access rule’, ATSs that exceed a certain threshold²³⁴ of the average daily trading volume of a single security are prohibited to unfairly exclude or limit market participants from accessing their services.²³⁵ Another significant change to traditional trading habits was made in 2000/ 2001 when the SEC implemented the decimalization of pricing which forced ex-

 Brummer, 84 Fordham L. Rev. (2015), 977– 1052, 1006 – 1007; cf. Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 17.  SEC, Securities Exchange Act Release No 34– 40760, 63 Fed. Reg. 70844 (Dec 22, 1998), 17 C.F.R. § 240.300 et seqq.  Palmer, Dark and Lit Markets: A User’s Guide, Institutional Investor Journals (2010), www. iinews.com/site/pdfs/liquidityii_flextrade.pdf (last visited Sept. 25, 2018); Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 20; Agarwal, High Frequency Trading: Evolution and the Future (2012), 4.  17 C.F.R. § 242.301(b)(1).  Cf. Brummer, 84 Fordham L. Rev. (2015), 977– 1052, 1007.  17 C.F.R. § 242.301(b)(3).  Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 21; Palmer, Dark and Lit Markets: A User’s Guide, Institutional Investor Journals (2010), www.iinews.com/site/pdfs/liquidityii_flextrade.pdf (last visited Sept. 25, 2018).  The threshold as required under the original rule of Regulation ATS amounted twenty percent but was lowered to five percent under Regulation NMS, see SEC, Final Rules, Regulation NMS, Release No. 51808 (June 9, 2005), Vol. 70 Fed. Reg. (June 29, 2005), 37496 – 37644, 37550, 37583.  17 C.F.R. § 242.301(b)(5).

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changes to start trading in penny increments instead of fractions of a dollar, e. g. bringing down the minimum spread between the bid and ask prices from onesixth of a dollar to one cent.²³⁶ Decimal pricing of securities allowed market prices to fluctuate more smoothly, requiring traders to quote in smaller price increments, thereby narrowing the bid-ask spreads.²³⁷ This regulatory change was designed to avoid a market participant gaining execution priority over a competing limit order by stepping ahead by an economically insignificant amount.²³⁸ On the downside, it directly fostered HFT as traders who previously profited from wider spreads were seeking for better, profit-making strategies requiring algorithms and speed.²³⁹ This in turn led to an increase of demand for dark trading opportunities. The great breakthrough for the growth of dark trading venues was caused by the adoption in 2005 and full implementation of Regulation National Market System (NMS)²⁴⁰ in 2007. Its main aim was to facilitate the creation of a ‘national market system’ by connecting various trading venues into one system, thereby decreasing fragmentation.²⁴¹ The increase of ECNs after the implementation of Regulation ATS had raised concerns that trades were not executed at the best price available and that ECNs practiced free riding on price information provided by the exchanges.²⁴² Regulation NMS, therefore, abolished rules that had protected the manual quotation systems of incumbent exchanges²⁴³ and implemented, in particular, the new ‘trade-through rule’, also called ‘order protection rule’²⁴⁴,

 Batista, 14 J. High Tech. L. (2014), 83, 92; Zaza, 18 Stan. J.L. Bus. & Fin. (2013), 319, 325; Agarwal, High Frequency Trading: Evolution and the Future (2012), 5. An illustrative example is given by Patterson, Dark Pools, 174– 176.  Zaza, 18 Stan. J.L. Bus. & Fin. (2013), 319, 325; Batista, 14 J. High Tech. L. (2014), 83, 92.  SEC, Concept Release No. 34– 44568, Request for Comment on the Effects of Decimal Trading in Subpennies (July 18, 2001), Vol. 66 Fed. Reg. (July 24, 2001), 38390 – 38396, 38390, 38395.  Agarwal, High Frequency Trading: Evolution and the Future (2012), 5; cf. Brummer, 84 Fordham L. Rev. (2015), 977– 1052, 1007.  SEC, Final Rules, Regulation NMS, Release No. 51808 (June 9, 2005), Vol. 70 Fed. Reg. (June 29, 2005), 37496 – 37644.  Zyskind, 91 Chicago-Kent L. Rev. (2016), 411, 416; Mercurio, 33 Rev. Banking & Fin. L. (2013 – 2014), 69 – 77, 71.  Brummer, 84 Fordham L. Rev. (2015), 977– 1052, 1009.  Zhu, 27 RFS (2014), 747, 752.  17 C.F.R. § 242.611; SEC, Final Rules, Regulation NMS, Release No. 51808 (June 9, 2005), Vol. 70 Fed. Reg. (June 29, 2005), 37496 – 37644, 37497 note 2 for clarification on the rule’s given name. As this rule intended to promote the protection of inter-market prices it is also referred to as ‘order-protection rule’; see Palmer, Dark and Lit Markets: A User’s Guide, Institutional Investor Journals (2010), www.iinews.com/site/pdfs/liquidityii_flextrade.pdf (last visited Sept. 25, 2018).

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to encourage limit orders and liquidity provision by restricting the execution of trades on one venue at prices lower than protected displayed quotations at another venue.²⁴⁵ If a better quotation was immediately and automatically accessible on another trading venue, then the current venue was required to either route orders to the trading venue with the best displayed price, regardless of the venue where the order was filed and regardless whether the venue was an exchange or alternative trading system,²⁴⁶ or to find a volume at the better price.²⁴⁷ This allowed traders to leverage and profit from small price differences if they were fast enough to take advantage of the momentary lag between them, which promoted the use of HFT.²⁴⁸ Thus, inadvertently Regulation NMS facilitated the initiation and development of dark pools to avoid the stricter transparency requirements and HFT, causing traditional exchanges to lose huge amounts of market share.²⁴⁹ From 2005 to 2015, the market share of trading on dark pools quadrupled reaching fifteen to eighteen percent of trading in exchange-listed securities.²⁵⁰

b. EU Market The European securities markets have undergone a change similar to the US market but a few years later. On November 1st, 2007, the EU enforced the Markets in Financial Instruments Directive (MiFID I)²⁵¹ which sought to promote the competitiveness of the financial markets in the EU and harmonize investor protection.²⁵² The new regulatory framework led to a fast expansion of equity trading venues causing a tremendous shift from “quasi-consolidated markets to fragmented  Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 20.  Zyskind, 91 Chicago-Kent L. Rev. (2016), 411, 416.  Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 20 – 21.  Clarke, 8 LFMR (2014), 342, 344; Agarwal, High Frequency Trading: Evolution and the Future (2012), 5.  Palmer, Dark and Lit Markets: A User’s Guide, Institutional Investor Journals (2010), www. iinews.com/site/pdfs/liquidityii_flextrade.pdf (last visited Sept. 25, 2018); cf. Mercurio, 33 Rev. Banking & Fin. L. (2013 – 2014), 69 – 77, 71.  Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 20; Commissioner Aguilar, Shedding Light on Dark Pools, SEC (Nov. 18, 2015), https://www.sec.gov/news/statement/shedding-light-on-dark-pools.html (last visited Sept. 25, 2018).  Markets in Financial Instruments Directive (Directive 2004/39/EC).  Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 11.

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markets” resulting in a sudden increase of competition.²⁵³ Three key changes derived from the enforcement of MiFID I: (1) abolishment of the concentration rule, which forced any regulated trade to be executed on the primary exchange and which, at that time, existed on most European exchanges, and thus, allowed free competition between all trading venues, (2) introduction of a comprehensive regulatory framework for trading in equity instruments irrespective of the trading method or platform, including internalization, and (3) extension of post-trade transparency duties to OTC trades (in regulated stocks) which, at the same time, fragmented the trade reporting activity by allowing entities other than the primary exchanges to report trades.²⁵⁴ MiFID I also introduced a new category of alternative trading venue, the multilateral trading facility (MTF)²⁵⁵, subject to pre- and post-trade transparency requirements and rules on customer protection, similar to those of RMs.²⁵⁶ Although some ATSs existed before the implementation of MiFID I, the competition between regulated trading facilities and those off-exchange trading facilities arose afterwards as the quasi-monopoly of the public exchanges was eliminated, reducing the costs of entry for new venues.²⁵⁷ Between 2008 and 2011 the share of equities trading on MTFs in Europe increased from zero percent to eighteen percent of turnover, currently accounting for around forty percent of equity trading volumes in the EU.²⁵⁸ However, since MiFID I also expanded the transparency regime and made it mandatory for RMs as well as MTFs to disclose the bid and offer prices and volumes in the order book on a continuous basis²⁵⁹ the demand of traders seeking for information leakage to hide large orders grew. To meet their needs new venues were established making use of the exemptions from the pre-trade transparency requirements, so-called waivers such as the ‘large-in-scale waivers’ for

 Gresse, Effects of Lit and Dark Market Fragmentation on Liquidity (Mar. 2016), 10; Zhu, 27 RFS (2014), 747, 752; within one year, in 2007– 2008, the quasi-monopoly of the traditional exchanges was threatened by the emergence of a handful of alternative trading venues: BATS Europe starting October 31, 2008; Chi-X starting March 30, 2007; Turquoise starting September 22, 2008; Nasdaq OMX Europe starting October 1, 2008.  Gresse, Effects of Lit and Dark Market Fragmentation on Liquidity (Mar. 2016), 11.  See above in section A.II.1.  Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 12.  Hammen, Boersen und multilaterale Handelssysteme im Wettbewerb (Exchanges and Multilateral Trading Systems in Competition), 19; Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 12.  Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 13.  See Art. 29(1) and Art. 44(1) MiFID I.

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large orders, the ‘reference-price waivers’ for execution of trades based on external references prices, and the ‘negotiated-price waivers’ for trades negotiated privately between participants.²⁶⁰ Consequently, this opened the floodgates for the rise of dark pools in the EU.

3. Globalization The explosive fragmentation of the markets resulting from the regulatory changes led to more competition initiating the development of innovative trading functionality, such as the possibility to execute trades in the dark without revealing information about the quotations, and also faster algorithms increasing trading speed and efficiency in order to attract and maintain order flow.²⁶¹ However, competition arose not only within the national markets but was further triggered internationally due to globalization.²⁶² Since the exchanges mainly focused on the development of electronic platforms they became more similar to alternative trading venues, and, because they all more or less traded the same securities, entered into direct competition in the operation of the secondary trading markets.²⁶³ This forced them to reconsider their business models, looking for new opportunities to increase, or at least, maintain their revenue.²⁶⁴ As a result, almost all exchanges today are run as profit maximizing businesses.²⁶⁵ They, for instance, generate and sell price and trade information and provide co-location services for high-frequency traders.²⁶⁶ Moreover, the global interconnection of the different markets facilitates the success of HFT strategies such as market arbitrage, allowing traders to take advantage from price discrepancies between prices, for example, on the NASDAQ and the LSE.²⁶⁷ Moreover, the global interconnection may put the financial mar-

 See Art. 29(2), (3) and Art. 44(2), (3) MiFID I; Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 13 – 14.  IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 4.  Coffee/Sale/Henderson, Securities Regulation, 601.  Ferrarini/Saguato, Regulting Financial Market Infrastructure, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 568, 576; Coffee/Sale/Henderson, Securities Regulation, 609.  Cf. Coffee/Sale/Henderson, Securities Regulation, 609.  Coffee/Sale/Henderson, Securities Regulation, 601.  Coffee/Sale/Henderson, Securities Regulation, 609.  Adler, 39 Vt. L. Rev. (2014), 161– 205, 177.

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kets’ stability at higher risk as small crises and crashes in one market can immediately have an impact on other markets.²⁶⁸ Globalization, therefore, causes new challenges for regulators who will have to pay attention not only to the effects on the national markets but on other markets as well. Regulatory changes in one market may certainly affect other markets if the regulations are not aligned and traders will move to certain markets which provide more or less restrictions in their favor. Consequently, this will have a huge impact on market liquidity and thus, on market efficiency. In particular, regulation of dark trading and HFT will likely trigger such development as it involves highly conflicting interests.

II. Other Factors The historical development can explain the rapid expansion of dark trading only to a certain extent. New technologies enabling and regulations allowing dark trading do not alone provide a sufficient explanation for the significant structural changes the markets have undergone. Rather, there were and are other reasons for such an interest in and demand for alternative trading venues and non-displayed trading opportunities.²⁶⁹ As previously noted, dark trading is not an entirely new phenomenon but has existed for many years, for example, in the upstairs market of the public exchanges, where dealers negotiated the execution of large block trades without revealing it to the general trading public; however, the automation of such practices and the widespread availability of different types of dark trading are new.²⁷⁰ But what exactly motivated traders in the past, and what motivates them today to move from the lit sector to the dark sector? This depends on the factors relevant to a trader in deciding where to place an order.²⁷¹ Two factors are particularly relevant to a trader’s decision on where

 This was demonstrated, for example, by the Flash Crash on May 6, 2010, see U.S. Commodity Futures Trading Commission/SEC, Findings Regarding the Market Events of May 6, 2010 (Sept. 30, 2010), 6; IOSCO Technical Committee, Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency (July 2011), 12.  Shorter/Miller, Dark Pools in Equity Trading: Policy Concerns and Recent Developments (Sept. 26, 2014), 4– 5 providing an overview of non-regulatory factors which presumably have influenced the growth of dark pools and which also apply to dark trading in general.  Cf. IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 10; Zaza, 18 Stan. J.L. Bus. & Fin. (2013), 319, 322– 323.  Cf. the results of a survey by IOSCO Technical Committee’s Standing Committee on Secondary Markets (TCSC2) published in IOSCO Technical Committee, Issues Raised by Dark Liquidity

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to place an order: a trader seeks the lowest costs and the best quality of service and execution. The financial costs of placing an order depend on the execution price of the trade, the fees paid for placing an order, and the speed and probability of execution of the trade depending on the level of liquidity.²⁷² The costs may also differ based upon the type of order: (1) market orders bear the costs of price movements (market impact costs), (2) limit orders, on the other hand, bear the costs of uncertain future developments.²⁷³ The execution price is influenced by the mechanism used to set the price of a security. Lit venues make their own price discovery, including all pre- and posttrade information to calculate the best bid and offer that determines the current price of a security.²⁷⁴ Dark pools, on the other hand, often refer to this price without adding their own (pre-trade) information to be included in the price determination.²⁷⁵ By executing trades at the midpoint of the reference price, securities prices can be improved and parties may save trading costs as both pay only half of the spread from the lit venue.²⁷⁶ Further, the execution price of a market order depends on the amount of market impact costs, which occur when the execution of the order moves the price of that security above/below the target price for a buy/sell order, and the price increases significantly when information is leaked about a large order before it is executed.²⁷⁷ Particularly those traders seeking to execute large block trades are usually exposed to the risk of higher market impact costs.²⁷⁸ Since dark pools do not provide, even at a minimum, pre-trade

(Oct. 2010), 10 – 11, listing a number of reasons why traders use dark pools, which apply in parts to dark trading in general.  Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 30.  Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 17.  Cf. Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 4; Francioni, An Exchange and Its Value, in: Francioni/Schwartz, Equity Markets in Transition, 15 – 69, 19, 35 – 37; Francioni/Reck/Schwartz, Secondary Market: Trading, Price Discovery, and Order Matching, in: Francioni/Schwartz, Equity Markets in Transition, 85, 85 – 86, 121.  Cf. Eng/Frank/Lyn, 12 J. Int’l Bus. & L. (2014), 39, 48; Francioni, An Exchange and Its Value, in: Francioni/Schwartz, Equity Markets in Transition, 15 – 69, 20.  Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 18, 30 – 31; Woehrmann, Institutional Investors and Exchange Organizations, in: Francioni/Schwartz, Equity Markets in Transition, 499, 514– 515.  Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 17. Cf. Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.12.  Gadinis, 3 Va. L. & Bus. Rev. (2008), 311– 356, 325.

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transparency, they attract traders who are concerned with information leakage influencing market impact costs when placing market orders.²⁷⁹ By using reference prices from lit venues which do not include dark trading information (at least pre-trade), large (market) orders placed on a dark pool are not represented in the best bid and offer and do not move the market price, thereby reducing market impact costs that otherwise would occur.²⁸⁰ Moreover, this is directly linked to the protection against HFT. As stated above, HFT strategies often cause trading disadvantages for other traders. Particularly, traders placing limit orders are exposed to the risk of predatory practices as limit orders are added to the order book and thus, are subject to pre-trade transparency rules on lit venues.²⁸¹ Dark pools, on the other hand, do not or only in parts provide pre-trade transparency, and often restrict access to high-frequency traders. Because of the reduced risks of information leakage, traders seeking to place limit orders may prefer dark pools.²⁸² Further, many exchanges charge fees for accessing the platform or becoming a member, and for trading (per-order fee). Usually, dark pools do not charge traders access fees and have lower trading fees, at least, for participants trading higher volume.²⁸³ Therefore, traders can minimize transaction costs by saving fees. Traders seeking to execute large block trades also often face difficulties due to a lack of depth in the lit orderbook. By attracting more traders for large blocks, some dark pools may be able to provide a higher level of liquidity for certain securities and thus, facilitate a faster execution of block trades in these securi-

 Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 17; Gadinis, 3 Va. L. & Bus. Rev. (2008), 311– 356, 325; Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.13 et seq.  Cf. Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 17; Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.12.  Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 17.  Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 17; Woehrmann, Institutional Investors and Exchange Organizations, in: Francioni/Schwartz, Equity Markets in Transition, 499, 515.  Woehrmann, Institutional Investors and Exchange Organizations, in: Francioni/Schwartz, Equity Markets in Transition, 499, 515; Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 32– 33 providing an overview of trading fees charged by dark pools in the EU.

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ties.²⁸⁴ However, in some circumstances dark pools may also bear the risk of lower execution probability as the increasing fragmentation enhances the competition for order flow and decreases the amount of liquidity in a single venue.²⁸⁵ In the end, the decision of a trader to place an order on a dark venue rather than on a lit venue depends on his personal needs and the individual trade-off between potential price improvement, influenced by costs and information leakage, and execution probability.²⁸⁶ These reasons to trade in the dark sector emerged for the first time, such as the reason to avoid algorithms or HFT, while others already existing were intensified (such as the desire to trade blocks or to avoid transaction costs on the public market), due to the innovations in technology and the shift to automated trading combined with the increasing use of sophisticated algorithms to execute trades at a rate that human traders can hardly compete with.

C. Conclusion to Chapter 1 Over the past few decades, the securities markets worldwide have been transforming. There are three main factors that led to the current market structure: (1) the technical development and the innovation of HFT strategies, (2) regulatory changes enhancing competition, (3) globalization enabling cross-border activity. While two decades ago trading took place on physical marketplaces by human traders primarily through telephone contact, today, marketplaces are mainly virtual and trading is conducted electronically through automated processes.²⁸⁷ The technical development spurred the growth of automated trading and the increasing use of algorithmic trading strategies, including HFT, and thus, led to more efficient trade execution. This resulted, on the one hand, in higher execution speed and lower costs. However, on the other hand, human

 Cf. Gadinis, 3 Va. L. & Bus. Rev. (2008), 311– 356, 326 – 327 stating that immediate and lowcost execution was a key advantage of the first ATSs in the US.  Cf. Adler, 39 Vt. L. Rev. (2014), 161– 205, 175; Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 33.  Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 18; Zhu, 27 RFS (2014), 747, 748; Gadinis, 3 Va. L. & Bus. Rev. (2008), 311– 356, 327. Cf. Woehrmann, Institutional Investors and Exchange Organizations, in: Francioni/ Schwartz, Equity Markets in Transition, 499, 507– 509.  Financial Conduct Authority, TR16/5: UK equity market dark pools – Role, promotion and oversight in wholesale markets (July 2016), 7.

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traders became unnecessary, competition increased among those trying to take advantage of the technical innovations, and unpredictable risks arose. At about the same time, regulators took steps to deregulate the securities markets to enable the growth of new trading venues and to enhance competition. While over ten years ago a majority of trades were executed on the primary exchanges, there are now several different kinds of trading venues, each of which can be distinguished by specific characteristics. These new trading venues address certain investors’ interests and needs and offer new trading opportunities that makes trading attractive for a new range of investors. Overall, not only did more trading venues enter the market, but also did more market participants. Some venues offered direct access to investors and allowed them to trade without intermediaries. High-frequency traders started to dominate the traditional exchanges, undermining institutional investors, and soon became the new market makers. Other investors were seeking opportunities to hide their trading information from being leaked to the public to save costs and to protect themselves from high-frequency traders. Venue operators took their chances to address these interests and offered restricted access to certain traders and trade execution at reference prices so that they did not have to reveal trading information in advance. As a consequence, the amount of OTC trading, or in other words, trading in the “dark sector”, which had taken place only in form of broker-dealer internalization, increased immensely due to the regulatory changes. Today, almost a third of the equity trades are executed in the dark. This development was further facilitated by globalization and the increasing interconnection of the different markets and enhanced cross-border activity. Overall, the current structure of the securities markets, particularly in the US and the EU, can be described as (1) highly technical and complex, (2) vastly fragmented, (3) with a high level of trading in the dark sector. While the consequences of the technical complexity and market fragmentation have already been analyzed and discussed among market participants in the past, the third characteristic only recently gave rise to concerns, and thus, gained more attraction. Dark trading – this term is now used to describe basically three forms of trading whereby only a limited amount or no trading information at all is revealed to the public and included into price discovery. It comprises (1) dark orders on lit venues, (2) trading in dark pools, and (3) broker-dealer internalization. However, within those three categories there are several complex variations and they are constantly developing due to technical advances. Although the differences are often negligible, they should be taken into consideration when drafting new regulations.

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The statistics provided in this chapter indicate that the demand for dark trading remains strong and the lit sector loses large parts of liquidity to the dark sector, which in the long run may lead to a loss of revenue.²⁸⁸ The rapid increase of dark pools in international markets implies that there is a strong need for the benefits provided by dark trading, in particular dark pools, such as minimizing information leakage, market impact costs as well as transaction costs and limiting a venue’s access to a certain group of traders.²⁸⁹ However, some market participants and regulatory authorities have raised concerns that the “increased activity in the dark is hurting the markets and investors”.²⁹⁰ Certainly, the former regulatory interventions fostering competition mainly led to the changes in market structure that cause the issues market participants and regulators are concerned about today. In response to those concerns and changes, many jurisdictions have recently undertaken regulatory steps to better integrate dark trading venues, to increase transparency, and to encourage trades back on to the lit venues.²⁹¹ However, the more regulators attempt to decrease fragmentation and to increase transparency, the more technical advancements are necessary to successfully compete in the market, and the more traders who cannot afford these advancements seek alternatives to avoid the disadvantages of this tough competition. The result is a rapid growth of dark trading opportunities, particularly dark pools. Consequently, as long as there is a demand for dark trading, traders will try to satisfy this demand, presumably at all costs, trying to find a loophole in the regulatory framework. The remaining question is, whether regulators have taken the right approach and whether further regulatory intervention is necessary to protect investors and to maintain the well-functioning of the markets. However, a higher degree of competition and increased speed have long been part of the trading evolution and thus, are by themselves not a sufficient cause for stricter regulation.²⁹² Rather, the answer depends largely on the actual impact of dark trading on the market – whether it is overall beneficial or harmful. This requires a careful analysis of the potential issues raised by dark trading which is subject of Chapter 2.

 See Bakie, Dark pool figures show growing global demand despite controversy, The Trade News (Jan. 19, 2016), http://www.thetradenews.com/Trading-Venues/Dark-pool-figures-showgrowing-global-demand-despite-controversy/ (last visited Sept. 25, 2018).  Cf. Preece/Rosov, 70 FAJ (2014), 33, 34.  Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 569.  Clarke, 8 LFMR (2014), 342, 343. A detailed assessment of the regulatory frameworks is provided in Ch. 3.  Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 484.

Chapter 2 The Impact of Dark Trading on The Market As dark trading has increased steadily, market participants and regulators have become more and more aware of its impact on the securities markets. However, experts disagree on whether the overall impact of dark trading is positive or negative.¹ There are two main views on the impact of dark trading on market quality: one side believes that dark venues have positively contributed to market innovations, competition, and reduced execution costs while the other side argues that dark trading has a negative impact, in particular, on transparency and the quality of price discovery.² Although dark trading has been subject to economic market analyses and empirical studies for many years,³ events like the “Flash Crash” on May 6, 2010 and the recent investigations into famous dark pools by the New York State Attorney General leading to fines amounting millions of dollars⁴ have raised regulators’ and market participants’ concerns and directed their attention towards dark trading. Today, it regularly hits the headlines in market news and is the trigger for heated debates among market participants.⁵ As pointed out in Chapter 1, there is a general demand for dark trading. Nevertheless, the latest de-

 Mercurio, 33 Rev. Banking & Fin. L. (2013 – 2014), 69 – 77, 70; Biedermann, 1 Public Finance Quarterly (2015), 78, 87.  SEC Division of Trading and Markets, Equity Market Structure Literature Review – Part I: Market Fragmentation (Oct. 7, 2013), 8.  Shapiro, U.S. Equity Markets: Recent Competitive Developments, in: Schwartz, Global Equity Markets, 19, 28 – 31; Macey/O’Hara, 28 J. Legal Stud. (1999), 17; Klock, 51 Fla. L. Rev. (1999), 753 – 797; Ganchev/Nevmyvaka/Kearns/Vaughan, 53 Commun. ACM (2010), 99 et seq.  Overview of all recent SEC actions against dark pools and other ATSs, including the amounts paid for the settlements, see SEC, Press Release 2016 – 264, Deutsche Bank Settles Charges of Misleading Clients About Order Router (Dec. 16, 2016), https://www.sec.gov/news/press release/2016 -264.html (last visited Sept. 25, 2018).  Davis, What, You Expected Deutsche Bank’s Dark Pool To Work As Advertised? (Dec. 16, 2016), https://dealbreaker.com/2016/12/deutsche-bank-dark-pool-bad/ (last visited Sept. 25, 2018); McDowell, Concerns raised around preferential matching within dark pools, The Trade News (Apr. 27, 2017), https://www.thetradenews.com/Sell-side/Concerns-raised-around-preferentialmatching-within-dark-pools/ (last visited Sept. 25, 2018); Bakie, Dark pool figures show growing global demand despite controversy, The Trade News (Jan. 19, 2016), http://www.thetradenews. com/Trading-Venues/Dark-pool-figures-show-growing-global-demand-despite-controversy/ (last visited Sept. 25, 2018). https://doi.org/10.1515/9783110661873-005

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velopments in securities regulation of the global players⁶ show their attempt to limit the amount of dark trading. However, the mere fact that trading in the dark sector is currently less regulated than trading in the lit sector does not by itself justify more regulatory intervention in this area. Before analyzing how and to what extent dark trading is regulated and whether changes are necessary and justifiable, the first question to be answered is why regulate dark trading at all. Regulation can be defined as the “employment of legal instruments for the implementation of social-economic policy objectives.”⁷ In the realm of securities regulation, regulatory actors in the major legal systems across the globe seek to achieve the following five fundamental goals: (1) investor protection, (2) improvement of market efficiency, (3) market integrity, (4) market quality, and (5) market stability.⁸ In a market economy, regulatory intervention should be entirely exceptional and thus needs sound justification.⁹ Regulators may employ legal instruments in

 See the summary of main regulatory steps in Ch. 1 (B.I.2.) and the detailed assessment in Ch. 3.  Den Hertog, General Theories of Regulation, in: Bouckaert/Geest, Encyclopedia of Law and Economics, 223, 223. For a more distinctive analysis see Ogus, Regulation, 1– 4; Baldwin/Cave/ Lodge, Understanding Regulation, 2– 3.  There are differences in regard to the number and the terms used to describe the core objectives, but the content of the objectives is largely consistent across regulatory systems. Often, the market’s efficiency, integrity, quality and stability are summarized as ‘functions of the market’. However, it is useful to distinguish them as they may be affected differently. See in general Veil, Concept and Aims of Capital Markets Regulation, in: Veil, European Capital Markets Law, 23, 24– 27; Moloney, EU Securities and Financial Markets Regulation, 2– 6; Oulds, 14. Teil: Allgemeiner Teil des Kapitalmarktrechts (Part 14: General Section of the Capital Markets Law), in: Kuempel/ Wittig, Bank- und Kapitalmarktrecht (Banking and Capital Markets Law), 14.1– 14.341, 14.141, 14.143 – 14.185; Kitch, Regulation of the Securities Market, in: Bouckaert/Geest, Encyclopedia of Law and Economics, 813, 822– 826; Austin, What Exactly is Market Integrity? An Analysis of One of the Core Objectives of Securities Regulation (July 27, 2016), 1, 23; IOSCO, Objectives and Principles of Securities Regulation (May 2003), 5 – 7. Traditionally, there were two major goals: market efficiency and investor protection. However, regulators and scholars recognized the importance of financial stability and, in response to the financial crisis, included the support of financial stability and the management of systemic risk into the governing objectives of securities regulation. See Moloney, EU Securities and Financial Markets Regulation, 2, 5 – 6; IOSCO, Objectives and Principles of Securities Regulation (May 2003), 6 – 7. In sum, the additional objectives are often seen as different shapes of the two central regulatory goals of ensuring the functioning of the markets and investor protection. See Veil, Concept and Aims of Capital Markets Regulation, in: Veil, European Capital Markets Law, 23, 26. This study, however, takes a more differentiated approach to provide a more profound analysis of the effects of dark trading.  Kumpan, Die Regulierung außerboerslicher Wertpapierhandelssysteme im deutschen, europaeischen und US-amerikanischen Recht (The Regulation of Over-the-Counter Trading Systems

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order to pursue and maintain the fundamental goals.¹⁰ Therefore, the answer to the question, why regulate dark trading at all, depends on whether and how dark trading affects these goals. The fundamental goals of securities regulation demonstrate the close relationship between the functioning of financial markets and the legal framework.¹¹ It is thus reasonable to adopt a law and economics approach in order to analyze the implications of dark trading and to determine whether the impact justifies regulatory intervention. This chapter examines the pros and cons of dark trading and how the different categories¹² of dark trading influence the objectives of securities regulation according to economic and legal studies. The main aim of the following literature review is to analyze the different opinions about the impact of dark trading and to evaluate the harms and benefits in order to provide the basis necessary for the assessment of the regulatory approaches and further recommendations as presented in Chapter 3 and 4. However, this chapter will not provide a new economic and empirical study that includes all relevant existing studies as this would exceed the scope of this study and should be reserved to economic researchers. Rather, the purpose of the following study is to provide a new perspective by reviewing both economic and legal literature in order to take into account the interdisciplinary character of the subject. It is further an attempt to add a valuable analysis for further conclusions about possible needs for action and regulation. The chapter is structured as follows. First, it categorizes the literature and gives an overview of the issues addressed (A.), before providing a detailed assessment of the relevant literature which has been reviewed in regard to the pros and cons of dark trading (B.), in order to compare the findings and draw an overall conclusion (C.).

A. Introduction to Evaluated Literature and Overview Several issues arise when reviewing literature that deal with the impact of dark trading. One major issue making it difficult to analyze whether dark trading has a positive or negative effect on the market and its participants is that data on

in German, European and US Law), 46. A more general overview of rationales for regulating is provided by Baldwin/Cave/Lodge, Understanding Regulation, 15 – 23.  Cf. Kumpan, Die Regulierung außerboerslicher Wertpapierhandelssysteme im deutschen, europaeischen und US-amerikanischen Recht (The Regulation of Over-the-Counter Trading Systems in German, European and US Law), 46.  Engelen, Remedies to International Asymmetries in Stock Markets, 13.  See details about categorization of dark trading in Ch. 1 (A.III.).

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dark trading is not publicly available to the extent necessary for empirical studies. Dark pools, for example, are only required to provide post-trade transparency with little information about their operation, participants and orders.¹³ Consequently, as most researchers work on a hypothetical basis and apply different market models, the research on the impact of dark trading on the securities markets has yielded very mixed conclusions.¹⁴ For the purpose of this study, it is neither possible nor useful to completely evaluate and present all the publications but rather to outline the main aspects and to analyze the findings. In order to shed light in the dark and to set the basis for the literature review (B.) this section first categorizes the literature (I.) and then identifies the main issues addressed by the researchers (II.).

I. Categorization of Literature In order to compare and reconcile the various theoretical and empirical studies, it is necessary not only to take a look at the findings and results, but to carefully consider the differences of the literature presented in the review. In 2013, the SEC published a series of literature reviews regarding the economic literature on equity market structure in order to assess whether market structure rules had kept pace with changes in trading technologies and practices, and to promote an exchange on market structure among the public and market participants.¹⁵ Following the SEC’s differentiation of the literature, four aspects are of major relevance for the review: (1) economic vs. legal analysis, (2) timeframe, (3) different countries, and (4) focus of particular study.

 Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 333; Gadinis, 3 Va. L. & Bus. Rev. (2008), 311– 356, 320 – 321.  Cf. Preece/Rosov, 70 FAJ (2014), 33, 35.  The Staff of the Division of Trading and Markets summarized economic papers that analyzed financial market data from 2007 and later in regard to three main issues raised in the SEC’s Concept Release on Equity Market Structure (2010), namely (1) the quality of performance of the current US equity market structure, including investor transaction costs, price discovery, and capital formation, (2) high-frequency trading, and (3) undisplayed liquidity. See SEC Division of Trading and Markets, Equity Market Structure Literature Review – Part I: Market Fragmentation (Oct. 7, 2013), 4 referring to SEC, Concept Release on Equity Market Structure, Proposed Rule, Release No. 61358 (Jan. 14, 2010), 75 Fed. Reg. (Jan. 21, 2010), 3594– 3614. See further SEC Division of Trading and Markets, Equity Market Structure Literature Review – Part II: High Frequency Trading (Mar. 18, 2014), 2.

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(1) Economic vs. Legal Analysis Most of the studies reviewed are written from an economic perspective and only a few from a legal perspective. Generally, economic studies focus more on the impact of dark trading on the market structure and market parameters. However, they usually do not take into account the various interests of the market participants which may be conflicting and which are important to determine whether regulatory intervention may be necessary and justified. Sometimes, the differences can lead to tensions, as the economic reality differs from the theoretical conception. One example is the dissemination of information: many legal scholars assume that equal access to information for all market participants is a fundamental regulatory goal, whereas economists recognize that, in reality, informational disparity is inevitable.¹⁶ Therefore, taking into account those differences and comparing the results of both economic and legal studies will be useful to draw a conclusion about the impact of dark trading in order to assess the regulatory regimes and the necessity of further regulatory intervention. However, the results of legal studies have to be interpreted carefully as many of them also rely on the findings of economic studies.

(2) Timeframe Due to the rapid technological developments and regulatory changes, the empirical studies differ very much depending on the time frame their analysis covers. In view of the main aim of this chapter to provide the basis for the assessment of the regulatory approaches and the question whether or not there is a need for regulatory changes, the following analysis considers empirical studies examining data from 2007 and later, under the current regulation.¹⁷

(3) Different Countries and Markets The review covers literature from different countries, mostly from the US and the EU but also from Australia and Canada, which have addressed similar issues and therefore, may be useful to reach an overall conclusion on the impact of dark trading on global markets. However, due to different market structures and dif-

 Engelen, Remedies to International Asymmetries in Stock Markets, 36 discussing the goal of market efficiency as an area of tension between lawyers and economists.  This time range considers the latest major regulatory changes in the US due to Regulation NMS and in the EU due to MiFID.

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ferent regulatory environments, not all of the results may be representative for the other markets to the same extent.¹⁸ Relevant differences will therefore be pointed out.

(4) Focus of Particular Study The most complex aspect is the focus of each particular study. Researchers usually have a large variety of different hypothetical models they can use. Furthermore, due to different data sets and metrics, significant differences may exist between theoretical and empirical studies.¹⁹ The findings may differ, in particular, according to different components and predictions considered to be important. For example, Garvey, Huang and Wu found that the differentiation between informed and uninformed traders matters.²⁰ Preece and Rosov discovered that the distinction between different types of off-exchange trading matters and that previous researchers did not make this distinction and therefore, may not provide sufficient results.²¹ Zhu and Ye find that results change depending on the assumption regarding the traders’ behavior; however, it should be noted that both Zhu and Ye base their studies on different underlying assumptions.²² Without greater expertise, it is difficult evaluate those differences and correctly measure their influence on the results. When reviewing theoretical and empirical studies regarding the impact of dark trading on the securities market, it becomes clear that there is a wide range of different findings and conclusions regarding the same subject of study, due to the lack of trading data available from the dark sector. Therefore, it is almost impossible to actually prove the existence of either harms or benefits by dark trading. However, this chapter attempts to draw a conclusion on whether it is significantly more probable that dark trading has a positive or a negative impact.

 Cf. SEC Division of Trading and Markets, Equity Market Structure Literature Review – Part I: Market Fragmentation (Oct. 7, 2013), 8; Mutschler, Internalisierung der Auftragsausfuehrung im Wertpapierhandel (Internalization of Order Execution in Securities Trading), 70.  Cf. Zhu, 27 RFS (2014), 747, 778 listing a number of reasons contributing to the differences among researchers.  Garvey/Huang/Wu, 68 J. Banking & Finance (2016), 12, 25.  Preece/Rosov, 70 FAJ (2014), 33, 35.  Zhu allows both informed and uninformed traders to freely select the trading venue, whereas Ye assumes that only the informed trader can freely select. Cf. Zhu, 27 RFS (2014), 747, 748 and Ye, A Glimpse into the Dark: Price Formation, Transaction Costs, and Market Share in the Crossing Network (June 19, 2011), 7.

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II. Overview of Main Issues Regulators and market participants are voicing concerns about the growing level of dark trading in US and European securities markets.²³ In particular, they worry that dark venues threaten the existence of lit venues, reduce the incentives to provide liquidity in the lit market and therefore, cause wider spreads resulting in higher trading costs and discouraging traders from participating in the market, which may lead to a decrease in market quality.²⁴ On the other hand, some researchers and market analysts also observe that not all of these concerns are justified.²⁵ For instance, dark trading is supposed to reduce implicit costs, i. e. the costs incurred due to bid offer spreads and price movements resulting from pre-trade transparency on exchanges.²⁶ By reducing the implicit costs dark trading may improve prices, complimenting the lit venues, and thereby leading to better investment performance.²⁷ Furthermore, dark trading presumably provides opportunities for investors to protect themselves against predatory trading practices by high-frequency traders.²⁸ It is evident that there are various interests involved, some of them conflicting – such as those of different kinds of investors – and each side presents com-

 Buti/Rindi/Werner, Dark Pool Trading Strategies, Market Quality and Welfare (Dec. 2015), 31; Foley/Putniņš J. Fin. Econ. (2016), 1, 2; Popper, Rise of Dark-Pool Trading Concerns Regulators, The New York Times (Mar. 31, 2013), https://www.nytimes.com/2013/04/01/business/as-marketheats-up-trading-slips-into-shadows.html (last visited Sept. 25, 2018).  Buti/Rindi/Werner, Dark Pool Trading Strategies, Market Quality and Welfare (Dec. 2015), 31.  Garvey/Huang/Wu, 68 J. Banking & Finance (2016), 12, 12, 25; Preece/Rosov, 70 FAJ (2014), 33, 44, 47; Zhu, 27 RFS (2014), 747, 779.  Woehrmann, Institutional Investors and Exchange Organizations, in: Francioni/Schwartz, Equity Markets in Transition, 499, 514– 515; Shorter/Miller, Dark Pools in Equity Trading: Policy Concerns and Recent Developments (Sept. 26, 2014), 5; Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 17, 30 – 31; Foley/Putniņš J. Fin. Econ. (2016), 1, 2; Preece/Rosov, 70 FAJ (2014), 33, 34; Barnes, CEO Turquoise talks about ’Dark Pools & Price Discovery’ at The Stock Market Show event in September 2015, https:// www.lseg.com/markets-products-and-services/our-markets/turquoise/turquoise-video-re sources/dark-pools-price-discovery (last visited Sept. 25, 2018).  Cf. Garvey/Huang/Wu, 68 J. Banking & Finance (2016), 12, 25; Marciello, 49 Suffolk U. L. Rev. (2016), 163, 181; Barnes, CEO Turquoise talks about ’Dark Pools & Price Discovery’ at The Stock Market Show event in September 2015, https://www.lseg.com/markets-products-and-services/ our-markets/turquoise/turquoise-video-resources/dark-pools-price-discovery (last visited Sept. 25, 2018).  Clarke, 8 LFMR (2014), 342, 347– 348; Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 11; Woehrmann, Institutional Investors and Exchange Organizations, in: Francioni/Schwartz, Equity Markets in Transition, 499, 515.

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pelling arguments about whether dark trading is either harmful or beneficial. It cannot be denied that dark trading has both pros and cons. The question, however, is whether the overall impact on the market is negative or positive. The mere fact that a phenomenon such as dark trading causes disadvantages for some market participants does not inevitably lead to the conclusion that dark trading is harmful per se. Rather, in the environment of a free market economy, competition creating advantages and disadvantages for different participants is a typical and essential feature.²⁹ Notably, competition also provides benefits to the market and economic growth. According to economic theory, a ‘perfectly competitive’ market will generate allocative and productive efficiency, whereas the lack of competition, i. e. pure monopoly³⁰, will assumedly lead to allocative and productive inefficiency.³¹ Allocative efficiency means that “the resources of society are being put to their most valuable use” and is the result of a ‘perfect’ balance of revenue and costs.³² It is generated if the number of competitors is large enough so that each will produce as much as necessary so that the marginal revenue of production equals the marginal costs, so that the marginal valuation of consumers will be equal to the marginal costs of producing the product and marginal social benefit will equal marginal social cost of production.³³ In a market occupied by a pure monopoly³⁴, where competition is deficient, the monopolist is able to determine the quantity produced and the price at which the product is sold, and hence, in order to maximize profits, will restrict its output and set prices above marginal costs.³⁵ This will lead to a transfer of income from consumers to producers, causing allocative inefficiency.³⁶ Further, the monopolist’s incentive to minimize the costs of production will be reduced, causing

 Ogus, Regulation, 22.  Monopoly describes the position in which one seller produces for the entire industry or market. See Baldwin/Cave/Lodge, Understanding Regulation, 15.  Ogus, Regulation, 22– 23.  Ogus, Regulation, 22.  Ogus, Regulation, 22. See for a detailed analysis of ‘perfect competition’ Towfigh/Petersen, Economic Methods for Lawyers, 50 – 52.  Monopoly describes a situation in which there is only one single seller producing for the entire market that cannot be entered by other firms due to substantial barriers, and the product sold cannot be substituted by another product. See Baldwin/Cave/Lodge, Understanding Regulation, 15 – 16.  Ogus, Regulation, 23; Baldwin/Cave/Lodge, Understanding Regulation, 16. See also Towfigh/ Petersen, Economic Methods for Lawyers, 53.  Baldwin/Cave/Lodge, Understanding Regulation, 16.

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productive inefficiency.³⁷ Without regulatory intervention, a pure monopoly may cause significant economic harm in the long-run. Hence, it is said that competition is “by far the most effective means of protection against monopoly” and “profit regulation is merely a ‘stop-gap’ until sufficient competition develops”.³⁸ In a ‘perfectly’ competitive environment only the most efficient competitor will prevail. Thus, creating competition in the market will provide incentives to improve efficiency, thereby naturally regulating the economic output and price setting.³⁹ Consequently, certain profits resulting from efficient business development and planned investment are desirable; the negative effects, i. e. losses of revenue for other competitors, are then acceptable and negligible.⁴⁰ However, excessive competition can sometimes also have contrary effects as in the case of so-called ruinous competition resulting from, for example, predatory pricing where, in a free market, a competitor dumps prices below the production costs and holds them there for a significant time.⁴¹ Such an excessive level of competition may lead to an increase of corporate collapses bearing the risk of economic welfare losses.⁴² Hence, an overall harmful impact on the market may only be prevented by regulatory intervention. In between those two extremes, pure monopoly and excessive competition, is a wide range of situations which to a greater or lesser extent inhibit or facilitate competition causing advantages and disadvantages among the market participants and thus, may or may not require regulatory intervention.⁴³ Therefore, it is important to distinguish between the sometimes negative ‘side effects’ of competition and an overall harmful impact putting the economic functions of securities market or individual investors at risk, resulting in a ‘market failure’. In order

 Ogus, Regulation, 23.  Baldwin/Cave/Lodge, Understanding Regulation, 452.  Cf. Towfigh/Petersen, Economic Methods for Lawyers, 54 arguing that monopolies’ supracompetitive profits incite entry into the market, resulting in competition which abolishes the losses caused by the monopolies.  Cf. Baldwin/Cave/Lodge, Understanding Regulation, 17 using windfall profits (excess profits) as an example.  Baldwin/Cave/Lodge, Understanding Regulation, 19 – 20; Kumpan, Die Regulierung außerboerslicher Wertpapierhandelssysteme im deutschen, europaeischen und US-amerikanischen Recht (The Regulation of Over-the-Counter Trading Systems in German, European and US Law), 54.  Kumpan, Die Regulierung außerboerslicher Wertpapierhandelssysteme im deutschen, europaeischen und US-amerikanischen Recht (The Regulation of Over-the-Counter Trading Systems in German, European and US Law), 54.  Cf. Ogus, Regulation, 23.

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to assess the impact of dark trading, the next part first determines the main areas that are of general concern to regulators and market participants as well as the different interests involved (1.), then specifies what effects are considered to be harmful or beneficial (2.), before identifying those areas affected by dark trading (3.) to set the basis for a detailed assessment of the impact of dark trading.

1. Primary Objectives of Securities Regulation Whether the impact of dark trading is considered to be negative or positive depends on the market parameters and interests affected by it. As set out above, regulatory intervention can only be justified if market parameters which are crucial for the functioning of the securities markets and/or the protection of investors are affected.⁴⁴ The main areas of concern are thus reflected in the fundamental goals of securities regulation. Although there are differences regarding the regulatory approaches, the core objectives coincide worldwide and even more strongly after the financial crisis of 2007– 2009 which revealed considerable regulatory and supervisory gaps in the global financial system.⁴⁵ In response, the G20 Pittsburgh Summit in 2009 introduced a regulatory reform focusing on propriety, integrity, transparency, and allocative efficiency to prevent a recurrence of those events that initially triggered the financial crisis.⁴⁶ The primary objectives can be summarized as follows: (1) investor protection, (2) market efficiency, (3) market quality, (4) market integrity, (5) market stability. The next part takes a closer look at the definition and concepts of each objective.

a. Investor Protection Investor protection is probably the most cited objective; however, it is a very broad term that particularly lacks further clarification in regard to what the in-

 Kumpan, Die Regulierung außerboerslicher Wertpapierhandelssysteme im deutschen, europaeischen und US-amerikanischen Recht (The Regulation of Over-the-Counter Trading Systems in German, European and US Law), 46.  Cf. Francioni, An Exchange and Its Value, in: Francioni/Schwartz, Equity Markets in Transition, 15 – 69, 63.  See Annex: ‘Core Values for Sustainable Economic Activity’ in G20, Leaders’ Statement: The Pittsburgh Summit (Sept. 24– 25, 2009), http://ec.europa.eu/archives/commission_2010 – 2014/ president/pdf/statement_20090826_en_2.pdf (last visited Sept. 25, 2018); cf. Francioni, An Exchange and Its Value, in: Francioni/Schwartz, Equity Markets in Transition, 15 – 69, 63.

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vestors need to be protected from.⁴⁷ The International Organization of Securities Commission (IOSCO), for example, points out that investors should be protected from misleading, manipulative or fraudulent trading practices.⁴⁸ Others take another approach and argue that investors on both sides, the selling-side and the buying-side, care about the quality of the financial market and hence, must be protected from purchasing mispriced securities.⁴⁹ This concept overlaps more with the second objective, market efficiency.⁵⁰ Moreover, it also remains unclear whether the goal is aimed at protecting a specific type of investor which may be particularly vulnerable and in need of protection or whether the protection covers all types of investors.⁵¹ Nevertheless, it is significantly important to acknowledge that there are different types of investors with different needs. Understanding these needs is essential for regulatory policy in securities markets.⁵²

b. Market Efficiency Another fundamental goal of securities regulation is the improvement of market efficiency. According to the efficient market hypothesis, an efficient financial market is one in which the dissemination of relevant information is timely and widespread and in which security prices always fully and correctly reflect all available information.⁵³ Efficient securities markets could help to improve the allocation of capital and reduce costs.⁵⁴ The aim of market efficiency has three dimensions: (1) institutional efficiency, (2) operational efficiency, and (3) allocational efficiency.⁵⁵ Institutional efficiency constitutes the criteria necessary for capital markets to

 Kitch, Regulation of the Securities Market, in: Bouckaert/Geest, Encyclopedia of Law and Economics, 813, 822.  IOSCO, Objectives and Principles of Securities Regulation (May 2003), 5.  Engelen, Remedies to International Asymmetries in Stock Markets, 31.  As the aim ‘investor protection’ often overlaps with other goals, Engelen argues that investor protection is actually reflected in the goals ‘market efficiency’ and ‘market liquidity’. See Engelen, Remedies to International Asymmetries in Stock Markets, 31, 45.  Veil, Concept and Aims of Capital Markets Regulation, in: Veil, European Capital Markets Law, 23, 25 – 26 pointing out that the EU regulations seem to take different approaches.  Gadinis, 3 Va. L. & Bus. Rev. (2008), 311– 356, 325.  Fama, 25 J. Finance (1970), 383 – 417, 383; IOSCO, Objectives and Principles of Securities Regulation (May 2003), 6; Engelen, Remedies to International Asymmetries in Stock Markets, 31– 32.  Veil, Concept and Aims of Capital Markets Regulation, in: Veil, European Capital Markets Law, 23, 25.  Veil, Concept and Aims of Capital Markets Regulation, in: Veil, European Capital Markets Law, 23, 25; Brinckmann, Foundations, in: Veil, European Capital Markets Law, 263, 266.

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function as markets.⁵⁶ Those criteria include liquidity and volatility and further investor confidence in the integrity and stability of the markets.⁵⁷ It is measured, in particular, on the basis of free market access for issuers and investors, a wide range of products and the depth of capital available on the market.⁵⁸ Operational efficiency is related to the transactional process and is measured in terms of reduced costs for issuers and investors.⁵⁹ Allocational efficiency describes the main function of the capital markets as matching investment opportunities with investible financial resources in order to achieve the highest return while ensuring a sufficient certainty for investors.⁶⁰ It requires investor confidence in the market which depends on transparency and disclosure of information and thus, is measured based on prices that immediately and fully reflect all available information.⁶¹

c. Market Quality The term ‘market quality’ refers to a market’s ability to meet its dual goals of liquidity and price discovery.⁶² Higher market quality is usually associated with lower transactions costs and more efficient prices.⁶³

d. Market Integrity The term ‘market integrity’ often overlaps with market fairness as well as investor protection and encompasses free access to the markets and equal treatment of all participants in the market.⁶⁴ It is supposed to be one factor to improve market

 Brinckmann, Foundations, in: Veil, European Capital Markets Law, 263, 268.  Brinckmann, Foundations, in: Veil, European Capital Markets Law, 263, 268.  Brinckmann, Foundations, in: Veil, European Capital Markets Law, 263, 268.  Brinckmann, Foundations, in: Veil, European Capital Markets Law, 263, 269; Veil, Concept and Aims of Capital Markets Regulation, in: Veil, European Capital Markets Law, 23, 25.  Brinckmann, Foundations, in: Veil, European Capital Markets Law, 263, 266; Veil, Concept and Aims of Capital Markets Regulation, in: Veil, European Capital Markets Law, 23, 25.  Veil, Concept and Aims of Capital Markets Regulation, in: Veil, European Capital Markets Law, 23, 25.  O’Hara/Ye, 100 J. Fin. Econ. (2011), 459, 463; Schwartz, 6 ZBB (2016), 387, 388 includes ‘intraday-volatility’ as a third characteristic; others measure it along liquidity, depth and volatility, see Gozluklu, 28 J. Fin. Markets (2016), 91, 100, 109.  O’Hara/Ye, 100 J. Fin. Econ. (2011), 459, 463.  Austin, What Exactly is Market Integrity? An Analysis of One of the Core Objectives of Securities Regulation (July 27, 2016), 22.

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efficiency.⁶⁵ As a fundamental goal of securities regulation, it requires the elimination of market abuse activities, non-discriminatory access to the market, transparent, and accurate information about the price, and issuance of securities available to all participants at the same time.⁶⁶

e. Market Stability Market stability⁶⁷ has been added to the fundamental objectives of securities regulation after the 2008 financial crisis which exposed the failure of regulators to recognize, monitor, and respond to systemic risks to financial stability.⁶⁸ Since then it has been the “chief worry” of regulators worldwide.⁶⁹ However, there is no uniformly accepted definition.⁷⁰ Market stability can generally be defined as “a condition in which an economy’s mechanism for pricing, allocating, and managing financial risks are functioning well enough to contribute to the performance of the economy”.⁷¹ It is thus closely connected with market efficiency. It encompasses the ability to deal with the emergence of imbalances and to prevent problems from growing into systemic risks.⁷²

 Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 600.  Austin, What Exactly is Market Integrity? An Analysis of One of the Core Objectives of Securities Regulation (July 27, 2016), 22– 23.  The goal ‘market stability’ is also referred to as financial stability and may further encompass the management of systemic risk. Moloney, EU Securities and Financial Markets Regulation, 5.  Moloney, EU Securities and Financial Markets Regulation, 4, 5 – 8 (more details on the development); Veil, Concept and Aims of Capital Markets Regulation, in: Veil, European Capital Markets Law, 23, 26.  Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 603.  See for an overview of a selected range of different definitions: Schinasi, Safeguarding Financial Stability, 82– 89.  Schinasi, Safeguarding Financial Stability, 83. Schinasi provides an even more detailed and profound definition of financial stability: “Financial Stability is a situation in which the financial system is capable of satisfactorily performing its three key functions simultaneously. First, the financial system is efficiently and smoothly facilitating the intertemporal allocation of resources from savers to investors and the allocation of economic resources generally. Second, forward-looking financial risks are being assessed and priced reasonably accurately and are being relatively well managed. Third, the financial system is in such condition that it can comfortably if not smoothly absorb financial and real economic surprises and shocks.”, see Schinasi, Safeguarding Financial Stability, 82.  Schinasi, Safeguarding Financial Stability, 85.

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2. Specification of Harms and Benefits As pointed out, regulation requires justification.⁷³ Thus, the impact must create a need for regulation. Mostly, this is the case if the impact causes ‘market failure’ which describes the situation where an unregulated market fails to “produce behavior or results in accordance with the public interest”.⁷⁴ Since the public interest is reflected in the core objectives of securities regulation as examined above, regulation may be justified if one or more of these objectives are adversely affected threatening the maintenance and further pursuit of the regulatory goals. Typical instances of market failure are the deterioration of competition due to monopolies, the underproduction of public goods due to the lack of incentives for production⁷⁵, and the inadequate production of information causing asymmetries among market participants.⁷⁶ A market failure inhibits capital formation and economic growth and prevents the market from performing its functions and achieving the goals of securities regulation.⁷⁷ Hence, it causes serious consequences for the whole economy, justifying regulatory intervention.⁷⁸ Whether an impact on the market is harmful or not, therefore depends on whether it causes a market failure or threatens investor protection.

3. Objectives and Interests Affected by Dark Trading After having determined the areas which are of general concern, the next step is to identify those areas which may actually be affected by dark trading. As examined in Chapter 1, dark trading takes place in the secondary market and affects, in particular, the (pre‐)trading period covering the stages of information gathering, order routing, and order matching. Furthermore, there are three main stake-

 Baldwin/Cave/Lodge, Understanding Regulation, 15.  Baldwin/Cave/Lodge, Understanding Regulation, 15; Ogus, Regulation, 29.  Public goods have to main characteristics: consumption by one person does not leave less for others to consume, and exclusion of those who do not pay from the benefit is impossible or too costly for the supplier. Thus, since some may enjoy the benefits of a public good without paying for it (‘free-rider problem’), suppliers will be less or not encouraged to produce the public good resulting in underproduction. See Ogus, Regulation, 33 – 35. A more detailed examination of the term ‘public good’ is provided below in section B.I.1. using a security’s price as an example.  Those and further examples of instances of market failure are provided by Ogus, Regulation, 30 – 46; Baldwin/Cave/Lodge, Understanding Regulation, 15 – 22; and Towfigh/Petersen, Economic Methods for Lawyers, 52– 58.  Cf. IOSCO, Objectives and Principles of Securities Regulation (May 2003), 8.  Kumpan, Die Regulierung außerboerslicher Wertpapierhandelssysteme im deutschen, europaeischen und US-amerikanischen Recht (The Regulation of Over-the-Counter Trading Systems in German, European and US Law), 51– 52.

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holders involved: (1) the operators of trading venues, (2) the different investors, and (3) the issuers of securities that are traded in the dark sector. The first stakeholder group, the venue operators, is mainly concerned about competition with other venue operators in attracting order flow. In general, venue operators care about liquidity in the market and reliable price discovery. Exchange operators, in particular, may be concerned about the diversion of order flow away from lit venues to dark venues due to market fragmentation.⁷⁹ This order migration may also adversely influence the incentive for traders to provide liquidity in the lit market, harming market quality.⁸⁰ Further, exchanges are responsible to provide a transparent and fair price discovery. As orders traded in the dark are not publicly displayed prior to the trade execution, they are not included in the price discovery process operated by the lit venues. Moreover, the prices in dark pools are not determined by internal demand and supply but are based on external references, such as the prices on the exchanges.⁸¹ Thus, dark trading may affect market quality by removing order flow from lit venues, potentially affecting liquidity, and thereby reducing the information contained in lit order books which is necessary for price discovery.⁸² The second stakeholder group, investors, is usually interested in making profits and therefore cares about fair and reliable prices and trading costs including fees. Investors are generally concerned about gathering relevant information about the securities. Thus, transparency plays a major role. Additionally, they care about fair access to the trading venues and fair trading practices. In regard to investor protection, it has to be taken into account that different investors have different needs and interests which may also conflict.⁸³ In particular, investors differ in regard to their level of information and sophistication.⁸⁴ The various trading venues are able to individually address the differences and satisfy the divergent needs. However, those differences may also lead to conflicts of interest which can require regulatory intervention. Investor protection and market integrity may be at risk if certain investors are excluded from or have limited access to dark pools or other forms of dark trading. As well, investors could be disadvan-

 Buti/Rindi/Werner, Dark Pool Trading Strategies, Market Quality and Welfare (Dec. 2015), 1.  Buti/Rindi/Werner, Dark Pool Trading Strategies, Market Quality and Welfare (Dec. 2015), 2.  Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 48.  Cf. Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 48.  Cf. Gadinis, 3 Va. L. & Bus. Rev. (2008), 311– 356, 325, 329.  Woehrmann, Institutional Investors and Exchange Organizations, in: Francioni/Schwartz, Equity Markets in Transition, 499, 506; Gadinis, 3 Va. L. & Bus. Rev. (2008), 311– 356, 327.

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taged due to information asymmetries or predatory trading practices in the dark. Dark pools usually do not disseminate trading information to the public but only to a select group of investors. As it was revealed that high-frequency traders were granted access to some dark pools and performed predatory trading practices, dark trading may also raise general concerns about its influence on market stability. The third stakeholder group, the issuers of certain securities that are traded in the dark sector, may also, at least indirectly, be affected by dark trading. Many of those issuers are companies that are listed in listed in specific stock market indices such as the DAX (Deutscher Aktienindex (German stock index)), the FTSE 100 (Financial Times Stock Exchange 100 Index), or the DJIA (Dow Jones Industrial Average). The listing in a specific stock index requires a certain threshold of trading volume and is significantly important for the reputation and the value of the company and its securities.⁸⁵ Thus, issuers care about meeting the requirements and remaining in the respective index. Their major concern is the dispersal of liquidity affecting trading volume which may be caused due to market fragmentation. The increase of different kinds of trading venues, and in particular the increase of dark trading, facilitates overall market fragmentation and may therefore pose a risk for issuers. Further, market fragmentation may lead to higher trading costs due to, for instance, lower execution probability and wider spreads, and inhibit the allocation of capital. Thus, regulators and market participants may generally be concerned about the impact of dark trading on fragmentation and hence, its effect on market efficiency. Among others, the IOSCO Technical Committee’s Standing Committee on Secondary Markets examined the key issues raised by dark trading, in particular by trading of equities in dark pools and the availability of dark orders on traditional equity exchanges.⁸⁶ The issues identified after the conduction of surveys among regulators, venues and traders in the dark sector coincide with the conclusions of the general analysis of concerns regarding dark trading. Those issues are as follows: (1) transparency and the impact on the price discovery process, (2) the impact of potential fragmentation on information and liquidity searches, and (3) the impact on market integrity due to possible differences in access to markets and information.⁸⁷ On the basis of these findings the next part assesses em-

 Heismann, “Dark Pools”: Wie alternative Plattformen den Aktienhandel bedrohen (“Dark pools”: How alternative trading platforms threaten stock trading), Wirtschaftswoche (Nov. 19, 2013), https://www.wiwo.de/finanzen/boerse/dark-pools-wie-alternative-plattformen-den-aktien handel-bedrohen/9082884.html (last visited Sept. 25, 2018).  See IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 5.  IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 19.

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pirical and theoretical studies which address these issues and evaluate the impact of dark trading.

B. Issues Raised in Regard to Dark Trading The main purpose of the following literature review is to assess whether the issues raised in regard to dark trading are actually proven to be true and whether dark trading adversely affects the securities market and the regulatory objectives in a way justifying regulatory intervention. The analysis focuses on the findings and conclusions of the different studies, whereas other factors like the underlying models, hypothesis and the data used will only be addressed if necessary to point out the differences among the studies. Deriving from the determination and identification of the major areas of impact by dark trading, the range of concerns can be narrowed down to the following four key issues: (1) lack of transparency and impact on price discovery, (2) the facilitation of market fragmentation and its impact on liquidity and companies listed in stock market indices, (3) fair access to information and trading venues, and (4) fair trading practices free of manipulation and predatory trading strategies.

I. Lack of Transparency and Impact on Price Discovery The price discovery process ought to be the key mechanism to achieve market integrity and market efficiency.⁸⁸ Therefore, one of the major issues discussed in regard to dark trading is the lack of transparency and the impact on the price discovery process.⁸⁹ Before assessing whether this impact is mainly harmful or beneficial (4.), it is necessary to understand why the price of a security is important and what it is relevant for (1.), how the price discovery process works (2.), and what kind of impact dark trading may have (3.).

 Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 600.  Cf. Apergis/Voliotis, 41 IRFA (2015), 101, 101; Zhu, 27 RFS (2014), 747, 747; Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 628.

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1. A Security’s Price Simply, a security’s price reflects its fundamental value according to the expectations of future returns which are based on all available information.⁹⁰ However, in actual markets, valuations differ across participants due to divergent expectations deriving from the different assessment of an enormous size of, usually, complex, incomplete, inexact and ambiguous public information.⁹¹ In an allocative efficient market, the price of a security reflects the value that best balances the broad market’s propensities to buy and to sell shares – demand and supply.⁹² Demand and supply, in turn, depend on other information regarding the respective security and the investors’ predictions and calculations about the security’s future value based on this information.⁹³ A market in which the prices “fully reflect” all available information is called “efficient” according to the efficient market hypothesis.⁹⁴ Since the establishment of allocative efficient markets is a fundamental goal of securities regulation, the accuracy of prices is of critical importance.⁹⁵ Moreover, on an organized exchange, the price is usually the primary rule of order execution, meaning that the highest bids are matched with the lowest offers.⁹⁶ The price is also relevant for a trader’s decision whether and when to submit an order and, in case of a limit order, at which price to place that order.⁹⁷ But a security’s price does not only play a role in regard to the security itself, it may also be used as a reference for, among others, accounting and tax purposes, to price derivatives, to determine the net asset value of mu-

 Engelen, Remedies to International Asymmetries in Stock Markets, 18, 38; cf. Schwartz, 6 ZBB (2016), 387, 391– 392; Teuber, Die Beeinflussung von Boersenkursen (Influencing Stock Market Prices), 9.  Schwartz, 6 ZBB (2016), 387, 391; Teuber, Die Beeinflussung von Boersenkursen (Influencing Stock Market Prices), 9, 38; cf. Francioni/Hazarika/Reck/Schwartz, Security Market Microstructure: The Analysis of a Non-frictionless Market, in: Francioni/Schwartz, Equity Markets in Transition, 292.  Schwartz, 6 ZBB (2016), 387, 392; Fleckner, Regulating Trading Practices, in: Moloney/Ferran/ Payne, The Oxford handbook of financial regulation, 596, 600.  Fama, 25 J. Finance (1970), 383 – 417, 383; Grüger, Kurspflege – Zulaessige Kurspflegemaßnahmen oder verbotene Kursmanipulation? (Price Management – Permitted Price Management Measures or Prohibited Price Manipulation?), 26.  Fama, 25 J. Finance (1970), 383 – 417, 383, introducing the efficient market hypothesis.  Engelen, Remedies to International Asymmetries in Stock Markets, 18.  Francioni/Reck/Schwartz, Secondary Market: Trading, Price Discovery, and Order Matching, in: Francioni/Schwartz, Equity Markets in Transition, 85, 94.  Francioni/Reck/Schwartz, Secondary Market: Trading, Price Discovery, and Order Matching, in: Francioni/Schwartz, Equity Markets in Transition, 85, 99.

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tual funds, and to value estates.⁹⁸ According to the efficient markets hypothesis, more accurate pricing of securities also contributes to more correct economic decisions throughout the economy.⁹⁹ It further removes uncertainty and strengthens investor confidence.¹⁰⁰ Thus, the quality of the formation of a security’s price is of critical importance and affects not only the traders of the respective security but the whole economy.¹⁰¹ A controversially discussed question is whether a security’s price is a public good.¹⁰² Public goods have three attributes: (1) a single quantity of the good is available for everyone, (2) one person’s consumption of the public good does not reduce the amount that is available for others, and (3) those who do not pay for the public good cannot be denied access to it.¹⁰³ Thus, a security’s price is considered a public good, because, after being published, it “is available for everyone to see, one person receiving that price does not reduce the amount available for others to see, and nonpayers are not excluded”.¹⁰⁴ However, some argue that those forming the prices, i. e. the public exchanges, should obtain property rights over the prices.¹⁰⁵ This would allow them to protect the price discovery process and to avoid other participants taking advantage and benefitting

 Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 603; Schwartz, 6 ZBB (2016), 387, 392.  Engelen, Remedies to International Asymmetries in Stock Markets, 19 referring to Kitch, Regulation of the Securities Market, in: Bouckaert/Geest, Encyclopedia of Law and Economics, 813, 824.  Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 600; Teuber, Die Beeinflussung von Boersenkursen (Influencing Stock Market Prices), 25 – 26.  Schwartz, 6 ZBB (2016), 387, 392; Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 600; cf. Teuber, Die Beeinflussung von Boersenkursen (Influencing Stock Market Prices), 20 et seq., 29.  Schwartz, 6 ZBB (2016), 387, 392; Rudolph/Röhrl, Grundfragen der Boersenorganisation aus oekonomischer Sicht (Basic questions of stock exchange organisation from an economic point of view), in: Hopt/Rudolph/Baum, Boersenreform (stock market reform), 143, 257, 259; Kumpan, Die Regulierung außerboerslicher Wertpapierhandelssysteme im deutschen, europaeischen und USamerikanischen Recht (The Regulation of Over-the-Counter Trading Systems in German, European and US Law), 87– 90; Hasbrouck, 50 J. Finance (1995), 1175, 1175, 1185.  Schwartz, 6 ZBB (2016), 387, 392; Kumpan, Die Regulierung außerboerslicher Wertpapierhandelssysteme im deutschen, europaeischen und US-amerikanischen Recht (The Regulation of Over-the-Counter Trading Systems in German, European and US Law), 87– 88.  Schwartz, 6 ZBB (2016), 387, 392 with further clarifications.  Mulherin/Netter/Overdahl, 34 J.L. & Econ. (1991), 591, 592, 644; Lehn, The Market for Marketplaces: Reflections on Market 2000, in: Schwartz, Global Equity Markets, 206, 214– 215.

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from using the prices for free – so-called ‘free-riding’.¹⁰⁶ But this argumentation lacks sound justification. First, distribution of the prices and production of the prices have to be distinguished.¹⁰⁷ The price itself is the mere result of matching two orders, an order to sell and an order to buy. If the investors would not send their orders, there would be no price to be discovered. Hence, the production is based on the investors’ actions, who make use of the exchanges and the pricing system they provide.¹⁰⁸ Thus, the exchanges do not produce the prices but only distribute them to the investors afterwards.¹⁰⁹ As the product, i. e. the price, is just the result of the traders’ interaction it cannot be considered the property of the exchanges on which the trade took place.¹¹⁰ The exchanges, however, also distribute the information on which the investors form their decisions to send orders, so-called pre-trade transparency. Therefore, the prices may include this information and indirectly be a product of the distribution process. This could give rise to the question whether the distribution process should be protected from others using it for free.¹¹¹ Regardless, this cannot justify to grant property rights over the price solely to the exchanges.¹¹² Thus, the security’s price is an unrestricted public good.

 Mulherin/Netter/Overdahl, 34 J.L. & Econ. (1991), 591, 592, 634, 644; Lehn, The Market for Marketplaces: Reflections on Market 2000, in: Schwartz, Global Equity Markets, 206, 214– 215.  Kumpan, Die Regulierung außerboerslicher Wertpapierhandelssysteme im deutschen, europaeischen und US-amerikanischen Recht (The Regulation of Over-the-Counter Trading Systems in German, European and US Law), 89.  Kumpan, Die Regulierung außerboerslicher Wertpapierhandelssysteme im deutschen, europaeischen und US-amerikanischen Recht (The Regulation of Over-the-Counter Trading Systems in German, European and US Law), 89.  Rudolph/Röhrl, Grundfragen der Boersenorganisation aus oekonomischer Sicht (Basic questions of stock exchange organisation from an economic point of view), in: Hopt/Rudolph/Baum, Boersenreform (stock market reform), 143, 260.  Thelen, Dark Pools – Schattenbörsen im Lichte US-amerikanischer, europäischer und deutscher Kapitalmarktregulierung (Dark Pools – Dark Trading Platforms in the Light of US-American, European and German Capital Market Regulation), 112 et seq. discusses whether informed traders obtain property rights over the prices as they produce the information contained in the prices. Thelen ultimately denies this with the argument that the informed traders themselves contribute to the dilution of property rights and have deliberately abandoned any property right.  This question will be discussed in further detail below in section B.I.3.b.  See also Thelen, Dark Pools – Schattenbörsen im Lichte US-amerikanischer, europäischer und deutscher Kapitalmarktregulierung (Dark Pools – Dark Trading Platforms in the Light of US-American, European and German Capital Market Regulation), 80 – 82 reaching the same conclusion.

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2. Price Discovery and Price Formation According to the IOSCO, price discovery is “the process through which the current market price for a security is established for, among other things, effecting an execution or valuing an existing holding”.¹¹³ While price determination occurs on a trade-by-trade basis, price discovery is achieved only as a substantial set of orders is brought together, generally over a succession of trades.¹¹⁴ The discovery of a security’s market price is derived from the supply and demand for the security, which indicates a trader’s willingness to transact at a certain price, and information about transactions which have already occurred: The more interest expressed, the more accurate the market price is likely to be.¹¹⁵ This requires information about supply and demand, i. e. pre-trade price and volume display, and thus, depends to a certain extent on transparency.¹¹⁶ Therefore, the more quickly and widely information is disseminated, the more instantaneously and fully the prices adjust to the information, and hence, the more accurate the prices are.¹¹⁷ In other words, the accuracy of prices largely depends on the dissemination of information.¹¹⁸ Since the same security can be traded on different venues at the same time, the process of producing equilibrium prices, i. e. prices reflecting supply and demand across the market as if all orders had been sent to one place, needs to consider all orders whether placed on the public exchange or on other venues.¹¹⁹ This may even require to include information from other global markets if the security is traded internationally.¹²⁰ A key element of the price discovery process is therefore the exchange of pre-trade and post-trade

 IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 19.  Price discovery can take place in different forms: order driven or through market making. Order driven means that all incoming orders are matched against the spread or stored in the central order book, applying the price-time priority. Market making has two possibilities: single or multiple market making. See for more details Francioni, An Exchange and Its Value, in: Francioni/Schwartz, Equity Markets in Transition, 15 – 69, 35.  IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 19; O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 107.  Cf. Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 579 – 580; O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 108; Groß, Kapitalmarktrecht (Capital Markets Law), § 24 BoersG, para. 10.  Engelen, Remedies to International Asymmetries in Stock Markets, 18.  Traditionally, three types of information can be distinguished: (1) information in historical market prices, (2) publicly available information, and (3) all information, irrespective of its public or non-public character. See Engelen, Remedies to International Asymmetries in Stock Markets, 32.  Cf. Kuempel/Wittig (eds.), Bank- und Kapitalmarktrecht, 4.253; Groß, Kapitalmarktrecht (Capital Markets Law), § 24 BoersG, para. 9.  Groß, Kapitalmarktrecht (Capital Markets Law), § 24 BoersG, para. 9.

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data.¹²¹ This, however, is a crucial factor when it comes to dark trading as it usually lacks, at least, pre-trade transparency.

3. Impact of Dark Trading on Price Discovery After having evaluated the significance of the price of a security and the main aspects of the price formation process, the next part examines the impact of dark trading on price discovery. The impact can be caused, in particular, by two factors: the lack of transparency (a.) and the reference price mechanism (b.).

a. Impact Due to Lack of Transparency As established in Chapter 1 the main characteristic of dark trading is its lack of transparency. Market transparency refers to the ability of market participants to observe information about the trading process, i. e. information about supply and demand.¹²² It can be distinguished between pre-trade transparency and post-trade transparency, both of which are essential for the price discovery process and thus, for the market to operate efficiently.¹²³ Pre-trade transparency covers information existing before a transaction is executed, transmitting knowledge of interest and willingness to transact at a certain price.¹²⁴ This includes the current bid and offer prices (quotes to buy or sell) and the depth of trading interests at those prices (volumes at the quotes).¹²⁵ Pre-

 Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 628; IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 19 – 20.  Madhavan/Porter/Weaver, 8 J. Fin. Markets (2005), 265, 267; cf. Seiffert/Lembke, Handelstransparenz (Trade Transparency), in: Ellenberger/Clouth, Praktikerhandbuch Wertpapierund Derivategeschaeft (Textbook on Securities and Derivatives Business), 875 – 908, para. 2367.  Francioni/Reck/Schwartz, Secondary Market: Trading, Price Discovery, and Order Matching, in: Francioni/Schwartz, Equity Markets in Transition, 85, 99; Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 628; Seiffert/ Lembke, Handelstransparenz (Trade Transparency), in: Ellenberger/Clouth, Praktikerhandbuch Wertpapier- und Derivategeschaeft (Textbook on Securities and Derivatives Business), 875 – 908, para. 2367– 2368.  O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 108; cf. Seiffert/Lembke, Handelstransparenz (Trade Transparency), in: Ellenberger/Clouth, Praktikerhandbuch Wertpapier- und Derivategeschaeft (Textbook on Securities and Derivatives Business), 875 – 908, para. 2369.  Madhavan/Porter/Weaver, 8 J. Fin. Markets (2005), 265, 268 note 2; cf. Comerton-Forde/ Putniņš, 118 J. Fin. Econ. (2015), 70, 72 note 4; Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 616; Seiffert/Lembke, Handelstransparenz (Trade Transparency), in: Ellenberger/Clouth, Praktikerhandbuch Wertpapier-

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trade transparency is considered to be a key element of the price discovery process.¹²⁶ If too many orders are not transparent or the information about transparent orders is unequal or incomplete, then the market cannot present sufficient information to participants about supply and demand and thus, cannot include this information into the price formation process.¹²⁷ Post-trade transparency covers information after the execution, particularly the size of the orders (volume), the price and the time at which they were executed, and the time at which the transaction was reported.¹²⁸ The information shall further include the identifier of the financial instrument and the identification code of the trading venue on which the execution took place in order to link them all together to gain exact information about the individual transaction.¹²⁹ Post-trade transparency is also considered a key element of the price discovery process.¹³⁰ It may even be more valuable than pre-trade transparency, as it was mentioned that “post-trade transparency is pre-trade transparency for the next trade”.¹³¹ Others, however, argue that post-trade data only indirectly affect price discovery, while pre-trade data immediately influence future prices.¹³² In the US, dark pools registered as broker-dealers are subject to pre-trade transparency requirements only if they display the orders to more than one system subscriber and if they exceed the threshold of five percent of the average

und Derivategeschaeft (Textbook on Securities and Derivatives Business), 875 – 908, para. 2369. See for the EU Art. 3(1) MiFIR.  IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 19; O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 108.  IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 19.  Madhavan/Porter/Weaver, 8 J. Fin. Markets (2005), 265, 268 note 2; cf. Seiffert/Lembke, Handelstransparenz (Trade Transparency), in: Ellenberger/Clouth, Praktikerhandbuch Wertpapierund Derivategeschaeft (Textbook on Securities and Derivatives Business), 875 – 908, para. 2370. See for the EU Art. 6(1) MiFIR.  In the EU, the requirements are specified by ESMA. See for example Table 3 in Annex I in ESMA, Regulatory Technical and Implementing Standards – Annex I to MiFID II/MiFIR (Sept. 28, 2015), https://www.esma.europa.eu/system/files_force/library/2015/11/2015-esma-1464_annex_ i_-_draft_rts_and_its_on_mifid_ii_and_mifir.pdf (last visited Sept. 25, 2018). For the US see for example 17 C.F.R. § 242.302 and FINRA Rules 6282(c) and 6431(b).  IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 20.  Barnes, CEO Turquoise talks about ’Dark Pools & Price Discovery’ at The Stock Market Show event in September 2015, https://www.lseg.com/markets-products-and-services/our-markets/ turquoise/turquoise-video-resources/dark-pools-price-discovery (last visited Sept. 25, 2018)  Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 617.

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daily trading volume.¹³³ However, most dark pools operate below this threshold. Regardless of any trading volume, broker-dealers are subject to post-trade transparency requirements and must transmit aggregate trading information to the self-regulatory organization (SRO), such as FINRA, of which they are a member.¹³⁴ The SRO will then publish the information, usually with a certain delay.¹³⁵ In the EU, the transparency regime was established under MiFID I and was recently extended by the new MiFID II/MiFIR. Although operators of dark pools are generally subject to pre-trade and post-trade transparency requirements, the EU regulations provide certain waivers that apply to (1) venues operating as price reference systems which execute trades at a price based on a primary exchange price (e. g. NBBO or EBBO), (2) venues that formalize negotiated transactions so that they take place at or within the current volume-weighted spread, (3) dark orders held on an RM or MTF, and (4) large-in-scale orders (e. g. block trades).¹³⁶ Dark pools operated under those waivers to be exempt from pre-trade transparency requirements. The new regime, however, introduced volume caps that will make it difficult to operate under the waivers on a regular basis.¹³⁷ In contrast to the US, the EU did not have a single consolidation system under MiFID I but several different systems and thus, although trading data was published, it was of poor quality and unreliable.¹³⁸ The new regime, however, introduced regulatory changes to address this issue.¹³⁹ Although dark trades are subject to post-trade transparency requirements, the published information usually does not identify the venue in which the trade took place and does not link the quotes to certain trades, making it impossible to determine whether they were executed away from the mid-point of the NBBO or the EU equivalent and thus, would have a price impact.¹⁴⁰ Consequent-

 17 C.F.R. § 242.301(b)(3). More details on regulatory transparency requirements are provided in Ch. 3 (B.I.1.d).  Cf. 17 C.F.R. § 242.601(a).  FINRA, for example, consolidates and posts the trading information on a two-week-delay basis on its website, available at https://otctransparency.finra.org/TradingParticipants (last visited Sept. 25, 2018).  Art. 29(2), 44(2) MiFID I and Art. 4 MiFIR. See also O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 111; Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.53 – 14.58.  Art. 5 MiFIR.  Moloney, EU Securities and Financial Markets Regulation, 454, 494.  See Ch. 3 (C.II.) for more details.  Nimalendran/Ray, 17 J. Fin. Markets (2014), 230, 236 – 267; Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 5 – 6.

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ly, this scope of post-trade transparency is of only little value for the price discovery process. As dark trades lack pre-trade transparency and provide only post-trade transparency, often with a certain delay, it can be concluded that dark trading does not contribute to the price discovery process on the pre-trade stage as required for lit trading. Since dark orders will not be reflected in the public price quote, concerns are raised that the public markets may not effectively display the true supply and demand in the markets.¹⁴¹ There is a risk that dark trading may divert order flow away from the lit venues and thereby reduce the information contained in the lit order books.¹⁴² Dark trades can be implemented in the prices only after the execution is completed. The lack of pre-trade transparency may inhibit appropriate price discovery resulting in less efficient prices.¹⁴³ Whether this impact on price discovery actually leads to negative results and causes harm to the market and market participants will be analyzed below (4).

b. Impact Due to Reference Pricing In today’s markets, the price discovery process is the primary function of the public exchanges.¹⁴⁴ It cannot be denied that dark trades benefit from the price discovery provided by the lit venues.¹⁴⁵ This may cause an advantage, particularly, for dark pools which compete directly with those lit venues. Since dark pools do not publish their quotes contrary to the lit venues which make their security prices publicly available, most dark pools rely on these freely accessible quotes to determine their own execution prices.¹⁴⁶ Some, therefore, claim that dark pools are ‘free-riding’ on the lit venue’s price discovery.¹⁴⁷ ‘Free-riding’ means that someone takes advantage of another person’s or company’s products

 Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 580; Shorter/Miller, Dark Pools in Equity Trading: Policy Concerns and Recent Developments (Sept. 26, 2014), 8.  Cf. Apergis/Voliotis, 41 IRFA (2015), 101, 101; Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 48.  Cf. Apergis/Voliotis, 41 IRFA (2015), 101, 101; Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 48.  Francioni/Reck/Schwartz, Secondary Market: Trading, Price Discovery, and Order Matching, in: Francioni/Schwartz, Equity Markets in Transition, 85, 86.  Eng/Frank/Lyn, 12 J. Int’l Bus. & L. (2014), 39, 48.  Eng/Frank/Lyn, 12 J. Int’l Bus. & L. (2014), 39, 48; cf. Financial Conduct Authority, Asymmetries in Dark Pool References Prices (Sept. 2016), 9. See Ch. 1 (A.III.2.b.ii.) for the differences in price determination according to the specific dark pool type.  Donald, 16 Eur. Bus. Org. L. Rev. (2015), 173, 188. This concern is mentioned by IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 19.

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and makes profit without giving any consideration in return.¹⁴⁸ Accordingly, dark pools would free-ride on the lit venues’ price discovery if lit venues pay for the price discovery process and the market expects those ‘using’ the prices as a reference to pay for it. Therefore, two questions arise: (1) whether lit venues pay for the price discovery process, and (2) whether dark pools referring to the prices on the lit venues are expected to give any, financial or non-financial, consideration in exchange. In order to answer the first question, it is necessary to take a look back at the price discovery process explained above. As previously discussed, the exchanges do not generate the prices but only distribute them. The price is formed from the exploitation of the information advantage of informed traders vis-à-vis uninformed counterparties and thus, represents an aggregate of all available information of the informed traders.¹⁴⁹ The exchanges only collect the information and provide the facilities to publish the price that automatically derives from supply and demand, thus from orders sent by investors. The actual costs are rather insignificant and, to a large extent, offset by the revenues from sources of income, including fees charged to listed companies and member firms.¹⁵⁰ The answer to the second questions, whether dark pools should pay a consideration for using the prices as a reference, depends on whether the security prices are considered a public good or whether the exchanges are granted property rights over the prices. As evaluated above, the better arguments are in favor of classifying a security’s price as a public good.¹⁵¹ Consequently, the prices are publicly available for everyone to use them as a reference – a consideration in return is not expected. However, despite the fact that the costs of the price discovery process are rather insignificant, it could be considered simply “unfair” if

 Kumpan, Die Regulierung außerboerslicher Wertpapierhandelssysteme im deutschen, europaeischen und US-amerikanischen Recht (The Regulation of Over-the-Counter Trading Systems in German, European and US Law), 88.  Consequently, not the exchanges but only the trading market participants – informed and uninformed – contribute to price formation. See Thelen, Dark Pools – Schattenbörsen im Lichte US-amerikanischer, europäischer und deutscher Kapitalmarktregulierung (Dark Pools – Dark Trading Platforms in the Light of US-American, European and German Capital Market Regulation), 112.  SEC Division of Market Regulations, Market 2000 (Jan. 1994), Study III, Market Fragmentation, Competition and Regulation, 3. The SEC argued that the exchanges were adequately compensated for providing the price discovery process which other competitors make us of. See for sources of revenues of securities exchanges Coffee/Sale/Henderson, Securities Regulation, 680.  See above (B.I.1.); cf. Thelen, Dark Pools – Schattenbörsen im Lichte US-amerikanischer, europäischer und deutscher Kapitalmarktregulierung (Dark Pools – Dark Trading Platforms in the Light of US-American, European and German Capital Market Regulation), 111 et seq.

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dark pools do not have to contribute to the price discovery but make use of it, whereas the exchanges are obliged to provide it: “The exchanges make no money but the dark pools benefit by not having to make a market. The market has been created for them.”¹⁵² Moreover, lit venues claim that they lose revenue as more transactions are executed in the dark that would otherwise be executed on a lit venue, thereby taking away trading volume from the lit venues.¹⁵³ However, the loss of revenue is mainly a result of market fragmentation and increasing competition and cannot be linked solely to the reference price mechanism.¹⁵⁴ There is no evidence that the exchanges would lose less revenue or that dark pools would attract less trading volume if they had to contribute to the price discovery.¹⁵⁵ Therefore, granting lit venues a property right over the prices or requiring dark pools to pay a consideration for the price referencing would not improve the price discovery process.¹⁵⁶ Hence, there is no indication that the reference price mechanism by dark trading has a harmful impact on the price discovery process due to free-riding.

 Eng/Frank/Lyn, 12 J. Int’l Bus. & L. (2014), 39, 48.  Donald, 16 Eur. Bus. Org. L. Rev. (2015), 173, 188.  Cf. Yadav, Dark Pools and the Decline of Market Governance (Mar. 25, 2016), 9.  Another question in this regard is whether dark pools free-ride on the exchanges’ market surveillance. Exchanges play a major role in self-regulation of the capital markets. While exchanges are subject to comprehensive rules to supervise market participants, dark pools have much less regulatory obligations. Thus, some claim that dark pools benefit from the market surveillance by the exchanges without any contribution. As a consequence, dark pools can save substantial costs. In order to compete with dark pools public exchanges are forced to attract more traders and therefore, have less intentions to strictly supervise the market and its participants. Overall, this may have adverse effects on market quality. For further details and prospective solutions see Thelen, Dark Pools – Schattenbörsen im Lichte US-amerikanischer, europäischer und deutscher Kapitalmarktregulierung (Dark Pools – Dark Trading Platforms in the Light of US-American, European and German Capital Market Regulation), 115 et seq. arguing that detrimental effects on the market can only be prevented by the introduction of a stricter liability regime.  Another question is whether the quality of the price discovery process suffers because the price is a public good and thus, the exchanges have less incentives to supervise it and to ensure that it is entirely market-driven, transparent, and fair. See Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 601– 602. Regulatory intervention could be necessary to secure the price discovery process. However, this issue arises due to the classification of the price as a public good and is not related to dark trading. It will therefore not be covered in this section.

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4. Analysis of Academic Literature After determining the impact of dark trading on the price discovery process, the remaining question is whether the impact due to lack of transparency causes harm to the overall market and its participants requiring and justifying regulatory intervention. Therefore, this section will summarize the main findings and conclusions of empirical and theoretical studies focusing on the impact on the price discovery process. The impact on price discovery is probably the most controversially discussed issue and the results differ widely. The differences depend on a number of factors. Theoretical studies, for example, have to anticipate the behavior of different types of investors. Empirical studies, on the other hand, cannot examine the impact of dark pre-trade data on price discovery as it is opaque and data samples are manifold. But most importantly, the price discovery process is influenced by so many different factors that neither theoretical nor empirical studies are able to separately contemplate the impact of one single factor – dark pools.¹⁵⁷ Further, differences across the different markets have to be taken into account. Differences may occur, for instance, in regard to the consolidation and dissemination of dark trading data¹⁵⁸, regulations regarding access to dark pools¹⁵⁹, and when and how the public receives data about dark trades (real-time or periodic with delay). Due to the lack of pre-trade transparency, the prices formed on the exchanges do not include information about dark orders. However, this does not consequently lead to the assumption that dark trading adversely affects price discovery and that price discovery would otherwise improve. If prices were purely market-driven and the price formation process would be based solely on supply and demand, this assumption could be proven true. Price discovery, however, also depends on other information contributed indirectly by informed traders. Moreover, informed traders may quickly detect anomalies in market prices and correct them.¹⁶⁰ Thus, if more informed traders trade on the lit venues, price discovery improves, but on the contrary, if more informed traders trade in the dark price, discovery is harmed.¹⁶¹ Hence, the dissemination of investors among the lit

 Mizuta/Kosugi/Kusumoto/Matsumoto et al., 12 Evolut Inst Econ Rev (2015), 375, 376.  As briefly discussed in Ch. 1 (B.I.2.) and further discussed in detail in Ch. 3, the US market implemented a consolidation system for quotation and trading data, whereas in the EU market data is published separately.  In the US and Australia, for example, dark venues are subject to lower regulatory requirements regarding fair access and therefore can exclude informed traders. See Comerton-Forde/ Putniņš, 118 J. Fin. Econ. (2015), 70, 73.  Chlistalla, High-frequency trading – Better than its reputation? (Feb. 7, 2011), 5.  Cf. Zhu, 27 RFS (2014), 747, 769, 779.

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sector and the dark sector plays an important role in valuing the impact on price discovery. Consistently, the studies focus on the segmentation of investors and how it is influenced by dark trading. Segmentation refers to the tendency of different types of investors to use different venues.¹⁶² The choice of venue is mainly driven by the trade-off of two factors: potential price improvement and the risk of no execution.¹⁶³ Generally, because informed orders are more positively correlated with the value of the security and thus, with each other, they are likely to cluster on either the buying or the selling side of the market.¹⁶⁴ Consequently, as the order size increases on one side, informed traders face lower execution probability in the dark than uninformed traders.¹⁶⁵ The results of different studies support the assumption that this difference in execution risk leads to segmentation of informed and uninformed orders with a tendency of more uninformed orders in the dark and more informed orders in the lit market.¹⁶⁶ The decrease of uninformed trades in lit venues may increase adverse selection risk, lead to wider bid-ask spreads, and reduce the profitability of acquiring private information, decreasing the overall production of information.¹⁶⁷ However, this does not yet provide any information about the effect of segmentation on price discovery. Zhu finds that, under natural conditions, adding a dark pool improves price discovery.¹⁶⁸ These findings are based on a hypothetical model of venue selection between an exchange and a dark pool by informed and uninformed traders.¹⁶⁹ Accordingly, if, for example, volatility is sufficiently low and thus, the price-improvement benefit of dark trading is lower than the costs of execution risk, informed traders are likely to choose the exchange, whereas uninformed traders tend to trade in a dark pool.¹⁷⁰ In this situation, the price formation is based more on informed order flow, improving the quality of the price discovery and hence the price itself. Thus, Zhu concludes that, due to the self-selection process by investors, under “natural conditions”, adding a dark pool improves price discovery.¹⁷¹

 Comerton-Forde/Putniņš, 118 J. Fin. Econ. (2015), 70, 73.  Zhu, 27 RFS (2014), 747, 748.  Zhu, 27 RFS (2014), 747, 748; Comerton-Forde/Putniņš, 118 J. Fin. Econ. (2015), 70, 73.  Zhu, 27 RFS (2014), 747, 748; Comerton-Forde/Putniņš, 118 J. Fin. Econ. (2015), 70, 73; Ye, A Glimpse into the Dark: Price Formation, Transaction Costs, and Market Share in the Crossing Network (June 19, 2011), 4– 5.  Zhu, 27 RFS (2014), 747, 748, 779; Comerton-Forde/Putniņš, 118 J. Fin. Econ. (2015), 70, 71, 73.  Comerton-Forde/Putniņš, 118 J. Fin. Econ. (2015), 70, 71, 73.  Zhu, 27 RFS (2014), 747, 779.  Zhu, 27 RFS (2014), 747, 748.  Zhu, 27 RFS (2014), 747, 748, 761.  Zhu, 27 RFS (2014), 747, 748, 779.

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Ye, on the contrary, finds that informed traders usually have a higher incentive to trade in the dark in order to hide their information, thereby increasing liquidity in the dark.¹⁷² According to Ye, adding a dark pool therefore harms price discovery, if and when an informed trader can trade in the dark pool.¹⁷³ However, Ye also concludes that, because informed trading in dark pools causes lower execution probability and decreases its competitiveness, it is in the dark pool’s own best interest to limit the impact of informed traders by, for example, changing its allocation rules.¹⁷⁴ Therefore, it will likely minimize the harmful impact on price discovery.¹⁷⁵ This, in turn, supports the assumption that, in practice, the impact on price discovery may not be overall harmful as the market, under natural conditions, will regulate itself. The reason why Zhu and Ye reach differing results is that they apply different assumptions for their models. Ye assumes that only the informed trader can freely select between the trading venues, contrary to Zhu who allows both the informed and the uninformed trader to select venues.¹⁷⁶ Moreover, the informed trader in Ye’s model acts as a monopolist, whereas in Zhu’s model many informed traders compete with each other. Zhu’s results are supported by empirical evidence provided by Ready who finds that in an environment where traders can freely select, informed traders less likely send their orders to the dark.¹⁷⁷ Also consistent with Zhu’s conclusions Apergis and Voliotis find that dark trading in the UK’s market leads to migration of liquidity and improved prices in the lit market.¹⁷⁸ They conclude that, due to the dissemination of information, the impact of dark trading on price discovery is actually not as harmful as many market participants and regulators assume.¹⁷⁹ The same conclusion is reached by Nimalendran and Ray providing empirical evidence for the US market.¹⁸⁰

 Ye, A Glimpse into the Dark: Price Formation, Transaction Costs, and Market Share in Crossing Network (June 19, 2011), 5 – 6.  Ye, A Glimpse into the Dark: Price Formation, Transaction Costs, and Market Share in Crossing Network (June 19, 2011), 39.  Ye, A Glimpse into the Dark: Price Formation, Transaction Costs, and Market Share in Crossing Network (June 19, 2011), 39.  Ye, A Glimpse into the Dark: Price Formation, Transaction Costs, and Market Share in Crossing Network (June 19, 2011), 39.  Ye, A Glimpse into the Dark: Price Formation, Transaction Costs, and Market Share in Crossing Network (June 19, 2011), 7; Zhu, 27 RFS (2014), 747, 748, 750.  Ready, Determinants of Volume in Dark Pool Crossing Networks (Apr. 16, 2014), 9, 45.  Apergis/Voliotis, 41 IRFA (2015), 101, 104, 105.  Apergis/Voliotis, 41 IRFA (2015), 101, 104, 105.  Nimalendran/Ray, 17 J. Fin. Markets (2014), 230, 233, 260.

the the the the the

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Also in line with Zhu’s prediction, Comerton-Forde and Putniņš find support that trades executed in the dark tend to be less informed than trades executed on lit venues correlated with the level of execution risk and adverse selection risk.¹⁸¹ Hence, informed traders are likely to supply liquidity to the lit market and thereby improve price discovery.¹⁸² However, they also assume that the segregation of traders may change the incentives to become informed leading to a decrease in information production which may ultimately harm price discovery.¹⁸³ As more informed traders migrate to the lit venue and more uninformed traders migrate to the dark, the level of competition on information decreases and fewer traders are willing to become informed or to acquire costly and precise information.¹⁸⁴ Comerton-Forde and Putniņš find evidence that high levels of dark trading, exceeding ten percent of the dollar volume in a given stock, harm informational efficiency and price discovery, low levels of dark trading, however, do not have a negative impact and may even be beneficial.¹⁸⁵ Moreover, the level of dark trading may differ from stock to stock. Thus, the aggregate market level of dark trading may be above the harmful threshold, whereas the level of some specific stocks may be below this threshold, and vice versa.¹⁸⁶ Notably, Comerton-Forde and Putniņš find evidence that not all dark trading has the same effects on price discovery and that there are differences, particularly, between large block trades executed as dark orders (on an exchange) and other dark trades executed, for example, in dark pools.¹⁸⁷ This result is supported by Hatheway, Kwan and Zheng who also find that large block trades do not harm market quality.¹⁸⁸ Further, in accordance with these findings, Preece and Rosov discovered that the threshold of the harmful level depends on the type of dark trading and the market capitalization of the stock.¹⁸⁹ Buchanan, Tse, Vincent, Lin and Kumar examine the impact of dark trading on price discovery for the EU market by analyzing statistical test. They do not find any evidence that dark trading causes significant differences in the price

 Comerton-Forde/Putniņš, 118 J. Fin. Econ. (2015), 70, 90.  Comerton-Forde/Putniņš, 118 J. Fin. Econ. (2015), 70, 81.  Comerton-Forde/Putniņš, 118 J. Fin. Econ. (2015), 70, 83.  Comerton-Forde/Putniņš, 118 J. Fin. Econ. (2015), 70, 83.  Comerton-Forde/Putniņš, 118 J. Fin. Econ. (2015), 70, 72, 90.  Cf. Comerton-Forde/Putniņš, 118 J. Fin. Econ. (2015), 70, 90.  Cf. Comerton-Forde/Putniņš, 118 J. Fin. Econ. (2015), 70, 90.  Hatheway/Kwan/Zheng, An Empirical Analysis of Market Segmentation on U.S. Equities Markets (Nov. 15, 2014), 31.  Preece/Rosov, 70 FAJ (2014), 33, 44 (internalization), 46 – 47, examining the impact on market quality in general by studying the effects on bid-offer spreads and market depth.

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discovery, and thus, conclude that dark trading does not harm the price discovery process but improves market quality.¹⁹⁰ Summing up the findings in the academic literature, there is no clear evidence proving that the lack of pre-trade transparency adversely affects price discovery to an extent that causes actual harm to market quality. However, most researchers agree that dark trading leads to partial segmentation of traders, resulting in a disproportionate dissemination of uninformed traders in the dark sector and informed traders in the lit sector. Although the effects of segmentation on price discovery are not entirely clear, there is evidence that some forms of dark trading, other than large block trades, have a harmful impact if they exceed a certain threshold. This threshold depends on the type of dark trading and the market capitalization of the financial instrument. The price discovery process and the price itself are affected only if the order volume is likely to significantly increase or decrease the liquidity in a certain financial instrument, which depends on the amount of securities issued.¹⁹¹ Thus, although in theory the lack of pre-trade data may lead to a deterioration of prices because they do not reflect all supply and demand, in practice, the lack of pre-trade transparency only matters if the order volume is sufficiently significant and therefore, may influence the overall amount of liquidity. Moreover, the threshold may differ among the markets and further empirical research is necessary in order to determine the exact threshold for the purposes of adjusting current regulation and aligning future regulation, accordingly. Consequently, some researchers recommend regulators to be cautious with implementing regulatory changes that could dramatically affect or limit dark trading, including, for example, volume caps on dark pools,¹⁹² which may lead to a deterioration of market quality and market efficiency.¹⁹³

 Buchanan/Tse/Vincent/Lin et al., Measuring Dark Pools’ Impact (Jan. 31, 2011), 3, 8. However, it is important to note that this study was fully funded by Credit Suisse – the operator of one of the biggest dark pools in the EU market.  Grüger, Kurspflege – Zulaessige Kurspflegemaßnahmen oder verbotene Kursmanipulation? (Price Management – Permitted Price Management Measures or Prohibited Price Manipulation?), 27.  The volume cap mechanism was recently implemented under the new EU regime, see Art. 5 MiFIR.  Buchanan/Tse/Vincent/Lin et al., Measuring Dark Pools’ Impact (Jan. 31, 2011), 8. See Comerton-Forde/Putniņš, 118 J. Fin. Econ. (2015), 70, 90 recommending consideration of differences in individual stocks and types of dark trading.

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II. Impact due to the Facilitation of Market Fragmentation The second major concern related to dark trading is the facilitation of market fragmentation and its impact on liquidity and companies listed in stock market indices. Over the past decade, regulators of the major securities markets promoted competition among trading venues leading to a boost in the emergence of new alternative trading venues. Whereas formerly, all order flow in a specific stock was centralized and largely handled on the primary exchange (except for a small portion executed through internalization) it is now fragmented among all venues competing with each other.¹⁹⁴ As a result, the primary exchanges have experienced huge losses in market share.¹⁹⁵ Overall, there are two instances that constitute market fragmentation: (1) when trading takes place simultaneously at different locations,¹⁹⁶ and (2) when the same security is traded on multiple trading venues.¹⁹⁷ It has become clear that dark trading is not the original cause of fragmentation, but it may facilitate it. Despite the more general discussion about whether the adverse effects of competition and fragmentation harm market quality and efficiency, or whether they are counterbalanced by the benefits of competition, the question at issue is whether dark trading, in particular, increases the adverse effects of fragmentation to an extent requiring and justifying regulatory intervention. Therefore, the next section first outlines how dark trading is related to fragmentation (1), second, examines how the fragmentation of volume between lit and dark trading venues (dark fragmentation) impacts the market (2), and third, assesses the findings and conclusions of related studies regarding the dimension of its impact (3).

 SEC Division of Trading and Markets, Equity Market Structure Literature Review – Part I: Market Fragmentation (Oct. 7, 2013), 6.  Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 626 – 627. Accordingly, the NYSE’s market share dropped from 79 percent in 2005 to roughly 25 percent in 2008 and in the EU, the LSE’s market share dropped from 96 percent in 2008 to below 50 percent in 2011.  Gresse, Effects of Lit and Dark Market Fragmentation on Liquidity (Mar. 2016), 1; Davies/Dufour/Scott-Quinn, The MiFID: Competition in a New European Equity Market Regulatory Structure, in: Ferrarini/Wymeersch, Investor Protection in Europe, 163, 164; O’Hara/Ye, 100 J. Fin. Econ. (2011), 459, 462.  Davies/Dufour/Scott-Quinn, The MiFID: Competition in a New European Equity Market Regulatory Structure, in: Ferrarini/Wymeersch, Investor Protection in Europe, 163, 164, 166; Gadinis, 3 Va. L. & Bus. Rev. (2008), 311– 356, 314.

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1. Dark Trading and Fragmentation Fragmentation increases as competition among trading venues for order flow in the same security increases.¹⁹⁸ In general, it is associated with benefits for investors, such as reduced trading costs and innovative trading services and products. However, it may also adversely affect the production of price information and trade execution.¹⁹⁹ In a neutral sense, the term ‘fragmentation’ describes the dispersal of volume among different venues.²⁰⁰ Furthermore, it can be distinguished between visible fragmentation (i. e. the dispersal of volume among lit trading venues) and dark fragmentation (i. e. the dispersal of volume between lit and dark trading venues).²⁰¹ For the purpose of this study, the following assessment focuses on dark fragmentation and issues related particularly to dark trading.

2. Impact of Dark Fragmentation Dark fragmentation may affect the market in several ways. Although competition and fragmentation may generally reduce trading costs, and thereby improving market quality,²⁰² it may also give rise to some concerns, two of which are particularly related to dark trading: (1) it may cause a dispersal of liquidity, thereby leading to an increase in trading costs, and (2) it may dilute the amount of trading volume of a specific stock, which is relevant for the calculation for stock market indices, and thereby putting issuers at risk of being delisted from stock indices.

 SEC, Concept Release on Equity Market Structure, Proposed Rule, Release No. 61358 (Jan. 14, 2010), 75 Fed. Reg. (Jan. 21, 2010), 3594– 3614, 3597; Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 580.  SEC Division of Trading and Markets, Equity Market Structure Literature Review – Part I: Market Fragmentation (Oct. 7, 2013), 6; SEC, Concept Release on Equity Market Structure, Proposed Rule, Release No. 61358 (Jan. 14, 2010), 75 Fed. Reg. (Jan. 21, 2010), 3594– 3614, 3597; Davies/Dufour/Scott-Quinn, The MiFID: Competition in a New European Equity Market Regulatory Structure, in: Ferrarini/Wymeersch, Investor Protection in Europe, 163, 166 – 167.  SEC Division of Trading and Markets, Equity Market Structure Literature Review – Part I: Market Fragmentation (Oct. 7, 2013), 8; cf. Fleckner, Regulating Trading Practices, in: Moloney/ Ferran/Payne, The Oxford handbook of financial regulation, 596, 627.  SEC Division of Trading and Markets, Equity Market Structure Literature Review – Part I: Market Fragmentation (Oct. 7, 2013), 8 – 9; Gresse, Effects of Lit and Dark Market Fragmentation on Liquidity (Mar. 2016), 1.  Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 47; SEC Division of Trading and Markets, Equity Market Structure Literature Review – Part I: Market Fragmentation (Oct. 7, 2013), 9.

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a. Impact of Dark Fragmentation on Liquidity Some argue that dark fragmentation reduces market liquidity and thus, is harmful per se. However, this assumption does not reflect a correct understanding of liquidity.²⁰³ It is therefore important to examine first, how liquidity is defined and created; second, how it affects market quality; and third, how dark trading and dark fragmentation may actually influence it. Liquidity is commonly defined as the ability to buy or to sell shares with reasonable speed, in reasonable quantity, and at a reasonable price.²⁰⁴ It depends on breadth, depth, and resiliency of the market.²⁰⁵ Put in more simple terms, a market is liquid if a trader is able to enter and exit an investment rapidly and cost-effectively.²⁰⁶ Liquidity is traditionally provided by three types of agents: classic market makers, high-frequency traders (“modern market makers”), and investors placing limit orders.²⁰⁷ Unlike a marketable order, which removes liquidity from the order book because it is executed immediately, a limit order adds liquidity to the book, as it remains there temporarily, though it awaits an uncertain execution.²⁰⁸ In an order driven market, low liquidity causes volatility with the result of wider spreads and increased market impact costs, leading to a decrease in trading interest, as well as lower execution probability. In an extreme situation, this may result in a market collapse and thus, cause a market failure.²⁰⁹ Generally, in an order-driven market liquidity influences the price of a security due to its impact on the spread and trading costs. As dark pools usually apply the reference price mechanism, their liquidity does not directly affect the execution price formed on the lit venue. However, it does affect the probability and speed of ex-

 Cf. Mutschler, Internalisierung der Auftragsausfuehrung im Wertpapierhandel (Internalization of Order Execution in Securities Trading), 90.  Schwartz, 6 ZBB (2016), 387, 390; cf. Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 332. See for a more detailed explanation Engelen, Remedies to International Asymmetries in Stock Markets, 39 – 40.  Schwartz, 6 ZBB (2016), 387, 390. See for a more detailed description of the individual components Woehrmann, Institutional Investors and Exchange Organizations, in: Francioni/ Schwartz, Equity Markets in Transition, 499, 505 – 506.  Yadav, Dark Pools and the Decline of Market Governance (Mar. 25, 2016), 17 with further references, noting that “the definition of liquidity in finance is notoriously problematic and complex”.  Schwartz, 6 ZBB (2016), 387, 392.  Bloomfield/O’Hara/Saar, 70 J. Finance (2015), 2227, 2245.  Schwartz, 6 ZBB (2016), 387, 393.

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ecution for an order, thereby determining trading costs.²¹⁰ When more orders are spread among different venues, the ability to match a buy and a sell order at a single venue decreases and consequently, trading costs increase.²¹¹ The more liquid a market is, the lower the trading costs are.²¹² Trading costs include search and information costs, costs of negotiating and monitoring, and enforcement costs.²¹³ They are influenced by the probability and speed of execution of an order.²¹⁴ A limit order may or may not execute, depending on the liquidity in the market and the asking price of the investor. If liquidity is low and the order either fails to execute or fails to execute at the asking price, the investor faces ‘nonexecution costs’.²¹⁵ The less liquid a market is, the more likely an order, particularly if it is large in size, will move the price and thereby increase market impact costs.²¹⁶ Lower liquidity also causes additional costs depending on the tightness of the price, i. e. the divergence of the prices from the mid-market price, measured in the prevailing bid-ask spread.²¹⁷ The wider the difference is between the bid-price and the ask-price, the lower the liquidity, resulting in costs for either the buy-side or sell-side. Hence, liquidity is important to reduce overall trading costs and thus, to improve market efficiency and market quality.

 Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 33; cf. Woehrmann, Institutional Investors and Exchange Organizations, in: Francioni/Schwartz, Equity Markets in Transition, 499, 515.  Cf. Comerton-Forde/Putniņš, 118 J. Fin. Econ. (2015), 70, 73; Gadinis, 3 Va. L. & Bus. Rev. (2008), 311– 356, 324.  Mutschler, Internalisierung der Auftragsausfuehrung im Wertpapierhandel (Internalization of Order Execution in Securities Trading), 90 – 91.  Engelen, Remedies to International Asymmetries in Stock Markets, 16.  Engelen, Remedies to International Asymmetries in Stock Markets, 39 – 40; Woehrmann, Institutional Investors and Exchange Organizations, in: Francioni/Schwartz, Equity Markets in Transition, 499, 505.  Hamon/Handa/Jacquillat/Schwartz, Market Structure and the Supply of Liquidity, in: Schwartz, Global Equity Markets, 76, 77.  Market impact is the expected price change conditioned on initiating a trade of a given size and a given sign, i. e. initiating a buy order should drive the price up, initiating a sell order should drive the price down. See Moro/Vicente/Moyano/Gerig et al., Market impact and trading profile of large trading orders in stock markets (Aug. 3, 2009), 5. The market impact depends on the market’s depth. See Woehrmann, Institutional Investors and Exchange Organizations, in: Francioni/Schwartz, Equity Markets in Transition, 499, 505 – 506.  Woehrmann, Institutional Investors and Exchange Organizations, in: Francioni/Schwartz, Equity Markets in Transition, 499, 505 with further explanation about how the bid-ask spread can be measured.

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Although dark fragmentation reduces liquidity in the single venues, it does not directly influence the overall amount of liquidity in the securities market.²¹⁸ Rather, it may also lead to an increase in liquidity as the alternative venues are able to meet individual investors’ needs and thereby attract more traders in total.²¹⁹ However, the main issue with regard to dark fragmentation is that liquidity in the dark is hidden and that there is no information on the liquidity in different venues for individual instruments.²²⁰ Sometimes, this information can be inferred from a variety of indicators. A reliable indicator is the Indication of Interest (IOI), which is a sales message sent from a broker-dealer to institutional customers within the trading venue reflecting an indication of interest to either buy or sell securities that usually contains all necessary information to agree on a trade.²²¹ However, the public does not have access to this information as IOIs are only sent to a select group of market participants.²²² Unless a trader can send and receive an IOI, he has to search for hidden liquidity. Searching for hidden liquidity implies high costs and may further enhance unwanted trading practices, such as pinging, i. e. the placing and cancelling of orders simply to discover hidden orders,²²³ and arbitrage strategies, i. e. the simultaneous purchase and sale of the same security in two different markets for advantageously different prices.²²⁴ Arbitrage is especially attractive if hidden liquidity leads to the situation that the same security is traded at different prices at the same moment in time, as buy and sell orders are spread among the venues, causing prices to only reflect market supply and demand at each individual venue (“excessive

 Cf. Kumpan, Die Regulierung außerboerslicher Wertpapierhandelssysteme im deutschen, europaeischen und US-amerikanischen Recht (The Regulation of Over-the-Counter Trading Systems in German, European and US Law), 75 – 76.  Kumpan, Die Regulierung außerboerslicher Wertpapierhandelssysteme im deutschen, europaeischen und US-amerikanischen Recht (The Regulation of Over-the-Counter Trading Systems in German, European and US Law), 78. See Woehrmann, Institutional Investors and Exchange Organizations, in: Francioni/Schwartz, Equity Markets in Transition, 499, 501, 515 stating that the number of institutional investors has increased immensely and that according to the SEC they positively affected the market, particularly by providing liquidity.  Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 33.  O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 106; cf. Shorter/Miller, Dark Pools in Equity Trading: Policy Concerns and Recent Developments (Sept. 26, 2014), 6; Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 345. See also the definition provided in Art. 2(1)(33) MiFIR.  Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 346.  Bloomfield/O’Hara/Saar, 70 J. Finance (2015), 2227, 2228.  Shleifer, Inefficient markets, 28; Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 4– 5.

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price dispersion”).²²⁵ Thus, the prices no longer accurately reflect supply and demand in the entire market and are therefore uninformative and unreliable.²²⁶ In sum, dark fragmentation may result in an increase in trading costs, including costs due to wider spreads and search costs in order to find hidden liquidity and identify the best price, and further deteriorate the securities prices.²²⁷ Dark fragmentation may therefore negatively impact market efficiency and market quality.

b. Impact of Dark Fragmentation on Stock Market Indices Despite the effect that dark fragmentation and the dispersal of trading volume may have on liquidity, they are also likely to affect issuers of certain securities that are listed in specific stock market indices such as the DAX (Deutscher Aktienindex (German stock index)), the FTSE 100 (Financial Times Stock Exchange 100 Index), or the DJIA (Dow Jones Industrial Average). The main function of stock indices is to represent the entire stock market or a specific market segment and to provide a reliable reference point for comparison of the listed companies.²²⁸ Being listed in a specific stock index is important for issuers as this represents a certain value of the company and its stock.²²⁹ For instance, being listed in the DAX, consisting of the 30 major German companies (Prime Standard) trading on the Frankfurt Stock Exchange, is more valuable than being listed in the MDAX, consisting of 50 Prime Standard companies ranking below the DAX. The admission of companies to those indices is mainly based on the trading vol-

 Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 627; Ferrarini/Saguato, Regulting Financial Market Infrastructure, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 568, 578.  Gadinis, 3 Va. L. & Bus. Rev. (2008), 311– 356, 314.  Ferrarini/Saguato, Regulting Financial Market Infrastructure, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 568, 578; Kumpan, Die Regulierung außerboerslicher Wertpapierhandelssysteme im deutschen, europaeischen und US-amerikanischen Recht (The Regulation of Over-the-Counter Trading Systems in German, European and US Law), 77.  Uhlir, Boersenindizes (Stock Indices), in: Gerke, Handwoerterbuch des Bank- und Finanzwesens (Dictionary of Banking and Finance), 382, 383. See also the explanation on “why we need benchmarks” available at https://us.spindices.com/index-literacy/what-is-an-index (last visited Sept. 25, 2018).  Heismann, “Dark Pools”: Wie alternative Plattformen den Aktienhandel bedrohen (“Dark pools”: How alternative trading platforms threaten stock trading), Wirtschaftswoche (Nov. 19, 2013), https://www.wiwo.de/finanzen/boerse/dark-pools-wie-alternative-plattformen-den-aktien handel-bedrohen/9082884.html (last visited Sept. 25, 2018).

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ume of the particular stock.²³⁰ Once they are listed they also have to continuously meet those criteria to remain listed in the indices.²³¹ If they fail to do so, they will be delisted.²³² Thus, the way trading volume is calculated is crucial for listed companies. The reference market for DAX listed companies, for instance, is Xetra, an electronic exchange.²³³ Similarly, the DJIA is calculated based on the trading volume on the NYSE.²³⁴ Hence, the trading volume is calculated exclusively based on exchange trading. Due to market fragmentation and the dispersal of trading volume, today, a considerable amount of stock is traded off-exchange in the dark sector and thus, is not taken into account.²³⁵ Moreover, a decrease in trading volume in those venues used as reference points for the calculation (i. e. the exchanges) may discourage certain investors from trading in the related securities, because they are required to invest only in those companies listed in specific segments or are restricted to investments in securities above a certain volume threshold.²³⁶ As the market share of dark trading increases, some companies fear being delisted from the indices. Others claim that the indices are no longer able to fulfill their function to provide a representative pic-

 Deutsche Boerse AG, Leitfaden zu den Aktienindizes der Deutsche Boerse AG (Guide to the Stock Indices of Deutsche Boerse AG) (Mar. 15, 2017), 22– 23, 38 et seqq. providing details on the calculaton; Heismann, “Dark Pools”: Wie alternative Plattformen den Aktienhandel bedrohen (“Dark pools”: How alternative trading platforms threaten stock trading), Wirtschaftswoche (Nov. 19, 2013), https://www.wiwo.de/finanzen/boerse/dark-pools-wie-alternative-plattformenden-aktienhandel-bedrohen/9082884.html (last visited Sept. 25, 2018). See also “eligibility and selection criteria” available at https://us.spindices.com/index-literacy/methodology-matters (last visited Sept. 25, 2018).  “An essential part of an index methodology is ensuring that an index remains consistent with its objective” available at https://us.spindices.com/index-literacy/methodology-matters (last visited Sept. 25, 2018).  Deutsche Boerse AG, Leitfaden zu den Aktienindizes der Deutsche Boerse AG (Guide to the Stock Indices of Deutsche Boerse AG) (Mar. 15, 2017), 34.  See Xetra, available at http://www.xetra.com/xlm_e/ (last visited Sept. 25, 2018).  Uhlir, Boersenindizes (Stock Indices), in: Gerke, Handwoerterbuch des Bank- und Finanzwesens (Dictionary of Banking and Finance), 382, 384– 385.  Heismann, “Dark Pools”: Wie alternative Plattformen den Aktienhandel bedrohen (“Dark pools”: How alternative trading platforms threaten stock trading), Wirtschaftswoche (Nov. 19, 2013), https://www.wiwo.de/finanzen/boerse/dark-pools-wie-alternative-plattformen-den-aktien handel-bedrohen/9082884.html (last visited Sept. 25, 2018). See Ch. 1 (B.) for statistics on the amount of dark trading.  Heismann, “Dark Pools”: Wie alternative Plattformen den Aktienhandel bedrohen (“Dark pools”: How alternative trading platforms threaten stock trading), Wirtschaftswoche (Nov. 19, 2013), https://www.wiwo.de/finanzen/boerse/dark-pools-wie-alternative-plattformen-den-aktien handel-bedrohen/9082884.html (last visited Sept. 25, 2018).

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ture of the market. Hence, voices are raised calling for a relaunch of the way trading volumes are calculated.²³⁷

3. Analysis of Academic Literature Although it is clear that dark fragmentation can adversely affect market efficiency and market quality, this does not inevitably lead to the conclusion that this impact causes harm to the overall market, as it may also be counterbalanced by the benefits of competition. Therefore, the final section of this part summarizes the main findings and conclusions of empirical and theoretical studies focusing on the impact of dark fragmentation on liquidity.²³⁸ However, it is important to consider the structural differences between the US and the EU securities markets. Although both markets are similarly spatially fragmented, the US market is largely virtually consolidated as part of the establishment of a National Market System²³⁹, whereas in the EU market fragmentation is more widespread as market data is not consolidated in a single system.²⁴⁰ O’Malley argues that overall, dark fragmentation provides benefits to the market as, for instance, trading in dark pools allows investors to save costs and thus, leads to price improvement.²⁴¹ Due to the reference price mechanism, many dark pools cross orders at the midpoint of the NBBO or an equivalent, thereby saving on the bid-offer spread and offering better prices.²⁴² Most dark pools also offer trade execution without intermediaries and do not charge exchange fees allowing traders to save on transaction costs.²⁴³ In addition to the reduction of trading costs, Gadinis points out that the various venues in a frag-

 Heismann, “Dark Pools”: Wie alternative Plattformen den Aktienhandel bedrohen (“Dark pools”: How alternative trading platforms threaten stock trading), Wirtschaftswoche (Nov. 19, 2013), https://www.wiwo.de/finanzen/boerse/dark-pools-wie-alternative-plattformen-den-aktien handel-bedrohen/9082884.html (last visited Sept. 25, 2018).  A very detailed overview and assessment of academic literature is provided by the SEC Division of Trading and Markets, Equity Market Structure Literature Review – Part I: Market Fragmentation (Oct. 7, 2013), 1 et seqq.  Market data, including quotes and trades, is consolidated through electronic communication systems. See for more details Ch. 3 (B.I.2.d.).  Cf. IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 20; O’Hara/Ye, 100 J. Fin. Econ. (2011), 459, 460 – 461.  O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 105 – 106.  O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 105.  O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 105. This is also supported by Woehrmann, Institutional Investors and Exchange Organizations, in: Francioni/Schwartz, Equity Markets in Transition, 499, 508 – 509, 515.

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mented market can better address the different investors’ needs, thereby attracting more order flow and increasing overall liquidity and informational efficiency.²⁴⁴ This assumption is supported by the empirical study of O’Hara and Ye who find that fragmentation lowers transaction costs by reducing effective spreads and increasing execution speed.²⁴⁵ Deriving from their findings they conclude that fragmentation facilitates competition in the US equity markets without degrading transactional or informational efficiency.²⁴⁶ However, their sample uses data from both lit and dark venues and hence, does not further distinguish between the differential impact on liquidity of visible and dark fragmentation.²⁴⁷ In their theoretical study Bloomfield, O’Hara and Saar find that by most measures, dark fragmentation affects liquidity and informational efficiency only slightly.²⁴⁸ On the contrary, dark trading affects individual trading strategies much more than the overall impact on the market. They find evidence that spreads in the dark sector are narrower and that informed traders make higher profits by dark trading.²⁴⁹ They conclude that within the context of a single market, trader strategies change with the market structure so that outcomes need not be uniquely determined by market rules.²⁵⁰ Consistent with those positive findings, Buti, Rindi and Werner theoretically and empirically observe that more dark pool activity is associated with narrower bid-ask spreads, more depth, and lower volatility, and thus, improves liquidity and overall market quality.²⁵¹ Notably, the authors observe that dark trading improves market quality at low levels but may have a harmful impact if it exceeds a certain threshold.²⁵² Further, Preece and Rosov find that dark fragmentation reduces indirect trading costs in form of lower bid-offer spreads and higher depth, and that dark

 Gadinis, 3 Va. L. & Bus. Rev. (2008), 311– 356, 328 – 329.  O’Hara/Ye, 100 J. Fin. Econ. (2011), 459, 471– 472 analyzing Nasdaq and NYSE stocks.  O’Hara/Ye, 100 J. Fin. Econ. (2011), 459, 472.  Cf. Degryse/de Jong/van Kervel, 19 RF (2015), 1587, 1588; SEC Division of Trading and Markets, Equity Market Structure Literature Review – Part I: Market Fragmentation (Oct. 7, 2013), 18.  Bloomfield/O’Hara/Saar, 70 J. Finance (2015), 2227, 2230.  Bloomfield/O’Hara/Saar, 70 J. Finance (2015), 2227, 2231.  Bloomfield/O’Hara/Saar, 70 J. Finance (2015), 2227, 2266.  Buti/Rindi/Werner, Diving Into Dark Pools (Nov. 17, 2011), 28; Buti/Rindi/Werner, Dark Pool Trading Strategies, Market Quality and Welfare (Dec. 2015), 3 – 4.  Buti/Rindi/Werner, Dark Pool Trading Strategies, Market Quality and Welfare (Dec. 2015), 3 – 4.

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pools facilitate the minimization of information leakage and market impact.²⁵³ Consistently with Buti, Rindi and Werner, they conclude that market quality declines if dark trading increases beyond a certain threshold, which depends on the type of dark trading and the capitalization of the financial instrument.²⁵⁴ Contrary to that, Degryse, de Jong and van Kervel, after empirically observing the differences between visible and dark fragmentation in EU markets find that the former is positively related to global depth, the latter, however, negatively in that an increase in dark trading is associated with a reduction in global depth.²⁵⁵ Additionally, they find proof that dark fragmentation does not only lead to a shift in liquidity from the lit market to the dark market but also harms overall spreads as more limit orders move to the dark market.²⁵⁶ Their results also provide evidence that dark pools attract uninformed order flow which in turn increases adverse selection costs on the lit venues, a so called ‘cream-skimming’ effect.²⁵⁷ Consequently, they conclude that dark fragmentation negatively affects liquidity.²⁵⁸ The main difference in contrast to Buti, Rindi and Werner is that Degryse, de Jong and van Kervel also include in their study data from internalization and other OTC trades which are usually larger in magnitude and thus, may more strongly influence the outcome, whereas the others focus on pure dark pool trading.²⁵⁹ This, in turn, supports the conclusion of the other researchers who find that the impact on market quality depends on the proportion of dark trading.²⁶⁰ Similarly, Hatheway, Kwan and Zheng observe that dark venues segregate order flow on the basis of asymmetric information risk and thereby increase adverse selection costs.²⁶¹ Further, they find that dark fragmentation is associated

 Preece/Rosov, 70 FAJ (2014), 33, 47. Preece discovered the same findings already in 2012 when preparing a study for the CFA Institute, see Preece, Dark Pools, Internalization, and Equity Market Quality (Oct. 2012), 54.  Preece/Rosov, 70 FAJ (2014), 33, 44, 47.  Degryse/de Jong/van Kervel, 19 RF (2015), 1587, 1590.  Degryse/de Jong/van Kervel, 19 RF (2015), 1587, 1591– 1592.  Degryse/de Jong/van Kervel, 19 RF (2015), 1587, 1619.  Degryse/de Jong/van Kervel, 19 RF (2015), 1587, 1619.  Cf. Buti/Rindi/Werner, Diving Into Dark Pools (Nov. 17, 2011), 4, 26; Degryse/de Jong/van Kervel, 19 RF (2015), 1587, 1592.  Cf. the results and conclusions by Preece/Rosov, 70 FAJ (2014), 33, 47 et seq. and Buti/Rindi/ Werner, Diving Into Dark Pools (Nov. 17, 2011), 26 et seqq.  Hatheway/Kwan/Zheng, An Empirical Analysis of Market Segmentation on U.S. Equities Markets (Nov. 15, 2014), 30.

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with higher transaction costs and lower price efficiency.²⁶² They conclude that order segmentation by dark venues, resulting from dark fragmentation, damages the overall market quality.²⁶³ The same conclusion is reached by Apergis and Voliotis who find that dark trading leads to a segmentation of traders as informed traders typically face relatively low execution probabilities in dark pools and thus, stay in the lit markets, whereas more uninformed traders choose to trade in dark markets.²⁶⁴ Consequently, dark pools ‘cream skim’ uninformed order flow causing a decrease in liquidity and an increase in adverse selection costs on the lit markets.²⁶⁵ For the Canadian markets, Madhavan, Porter and Weaver analyze empirically the impact of an increase in pre-trade transparency regarding the limit order book and find that higher transparency does not improve market quality.²⁶⁶ Their results show that an increase in transparency raises execution costs and reduces liquidity leading to significant declines in stock prices.²⁶⁷ Thus, they conclude that, due to the lack of transparency, dark trading may benefit markets.²⁶⁸ However, their research does not confirm this argumentum e contrario. All in all, the different analyses show that a higher proportion of dark trading causing dark fragmentation likely leads to a shift of liquidity from the lit market to the dark market. The shift of liquidity may further impose negative effects such as higher trading costs, particularly in searching for hidden liquidity, and the deterioration of prices, the segmentation of informed and uninformed traders causing a higher adverse selection risk. However, fragmentation may also enhance competition and therefore provide benefits, such as a decrease in fees and an increase in order flow due to a wider range of trading services attracting more investors. Consequently, shift of liquidity is not harmful per se, if higher trading costs are still counterbalanced by gains and profits.²⁶⁹ However, the empirical and theoretical findings provide evidence that if dark trading exceeds a certain threshold, negative effects are likely to outweigh the benefits. This

 Hatheway/Kwan/Zheng, An Empirical Analysis of Market Segmentation on U.S. Equities Markets (Nov. 15, 2014), 31.  Hatheway/Kwan/Zheng, An Empirical Analysis of Market Segmentation on U.S. Equities Markets (Nov. 15, 2014), 3, 30 – 31.  Apergis/Voliotis, 41 IRFA (2015), 101, 104.  Apergis/Voliotis, 41 IRFA (2015), 101, 104– 105.  Madhavan/Porter/Weaver, 8 J. Fin. Markets (2005), 265, 268, 286.  Madhavan/Porter/Weaver, 8 J. Fin. Markets (2005), 265, 268.  Madhavan/Porter/Weaver, 8 J. Fin. Markets (2005), 265, 287.  Cf. Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 48.

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threshold may differ among the markets; however, further specifications require a more profound individual cost-benefit-analysis. Thus, in the end, “any regulatory response to market fragmentation will be a trade-off between fostering competition among marketplaces and factoring in as many orders as possible for price formation”.²⁷⁰

III. Fair Access to Information and Trading Venues Due to the current market structure creating fragmented securities markets, the trading venues compete for order flow and thus, for traders. In this competitive environment traders can choose among a variety of venues which generally address different type of traders. The differences of investors regarding their level of expertise and their level of information are outlined above.²⁷¹ Usually, they also pursue different interests and goals. In order to decide where to trade, the investors need information, including general trading information about liquidity and prices. Further, information about the operation of a particular trading venue may be useful, such as execution rules (i. e. based on time priority), the types of participants (i. e. HFT), and the distribution of information among participants (i. e. IOIs).²⁷² As stated, information is essential for investors to make optimal investment decisions and thus, is crucial for market efficiency.²⁷³ It is important, however, to identify the kind of information that is subject to the asymmetry and differentiate between outside information, i. e. company related information, and information related to the venues and securities traded, i. e. information about liquidity and prices.²⁷⁴ Informational asymmetries based on outside information may harm the markets and investors but they are not directly related to dark trading and hence, will not be subject to the following assessment.²⁷⁵ Rather, the focus is on informational asymmetries resulting from the different level of information in respect

 Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 627.  See above in section A.II.3.  Cf. IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 22.  Brinckmann, Foundations, in: Veil, European Capital Markets Law, 263, 265 – 266, 268 – 269.  Cf. the distinction between outside information and information from inside the dark sector by Mills, The Rise of the Dark Side; Dark pool trading and the two-tiered implication (June 2014), 34– 35.  A typical example of informational asymmetries based on outside information is the case of insider trading, which is legally prohibited in many jurisdictions.

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of information contained within the dark sector, such as information about hidden liquidity, transaction prices and operational procedures. This leads to the first issue: As dark trades and dark pools are opaque to the public and provide only limited information, not all traders may be able to get equitable access to the information necessary and thus, some may be disadvantaged. Once the traders gathered all – or at least part of – the relevant information they may choose a trading venue according to their needs. However, not every trading venue provides unrestricted access. As stated in Chapter 1, dark pools do not have an obligation to offer membership to every trader and may exclude certain traders. Thus, the second issue concerns how dark pools restrict the access or select their customers. As the IOSCO pointed out, the regulatory objectives ‘market integrity’ and ‘investor protection’ are closely linked to each other and regulators should aim to ensure that investors are given fair access to market facilities and information.²⁷⁶ Further, market efficiency requires that investors have access to timely and widespread information in order to ensure efficient and accurate price formation.²⁷⁷ The impact of dark trading on price discovery as a matter of pursuing market efficiency was discussed previously.²⁷⁸ The following paragraph thus focuses on the impact of dark trading on market integrity and investor protection by addressing the concerns about (1) fair access to information and (2) fair access to trading venues.

1. Impact Due to Lack of Information As discussed in the context of the impact on price discovery, dark trading is usually exempt from pre-trade transparency requirements. Despite the economic impact on, for instance, price discovery, the lack of information may cause informational asymmetries and thereby inhibit investor protection, market integrity and market efficiency. In this regard a distinction can be made between basically two instances: (1) a general lack of information concerning all traders, and (2) restricted access to information dependent on the type of investor. The first issue may adversely affect market efficiency by leading to a segmentation of traders among the venues and thereby increasing trading costs

 IOSCO, Objectives and Principles of Securities Regulation (May 2003), 6, referring to market fairness as a synonym for market integrity which is used in the present study; see also IOSCO, Objectives and Principles of Securities Regulation (Feb. 2008), 6.  IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 20 – 21; cf. the general remarks on efficiency above in section A.II.1.b.  See above in section B.I.

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and adverse selection costs in the lit markets.²⁷⁹ However, it does not cause informational asymmetries between the traders. In contrast to that, the second instance raises serious concerns as it may disadvantage those market participants that do not receive the information.²⁸⁰ Legal researchers and regulators worry that this unequal access to information would create a ‘two-tiered market’.²⁸¹ Informational asymmetries can occur, first, between traders in the lit sector and traders in the dark sector, and second, among dark traders.

a. Informational Asymmetries Between Lit Traders and Dark Traders As the dark sector does not reveal information to the public, informational asymmetries may simply arise if certain investors get access to this information by trading in the dark. Consequently, traders in the lit sector only have the publicly available information about liquidity and prices in the lit sector, whereas traders in the dark in addition have access to information about hidden liquidity and prices in the specific dark sector they participate in.²⁸² If the information stemming from the dark sector does not match the public information, those investors with both information gain an advantage over the public which may result in further benefits.²⁸³ Moreover, each individual dark pool usually provides information only to its own participants and does not share it with other dark pools.²⁸⁴ In order to increase the amount of dark information, an investor may seek to participate in as many dark pools as possible. This, however, is associat-

 Cf. inter alia Hatheway/Kwan/Zheng, An Empirical Analysis of Market Segmentation on U.S. Equities Markets (Nov. 15, 2014), 30; Apergis/Voliotis, 41 IRFA (2015), 101, 104.  IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 22; Boni/Brown/ Leach, Dark Pool Exclusivity Matters (Dec. 19, 2013), 2; Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 581.  IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 22; Young/Pettifer/ Fournier, 28 IFLR (2010), 25, 25; Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 581; Mills, The Rise of the Dark Side; Dark pool trading and the two-tiered implication (June 2014), 3; Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 346 – 347.  Mills, The Rise of the Dark Side; Dark pool trading and the two-tiered implication (June 2014), 3, 16 – 17; Young/Pettifer/Fournier, 28 IFLR (2010), 25, 25; cf. Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 346.  Mills, The Rise of the Dark Side; Dark pool trading and the two-tiered implication (June 2014), 33.  Mills, The Rise of the Dark Side; Dark pool trading and the two-tiered implication (June 2014), 16 – 17.

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ed with high costs and thus, privileges usually big institutional investors, thereby intensifying the two-tiered market.²⁸⁵

b. Informational Asymmetries Among Dark Traders Further, informational asymmetries can arise among dark traders within a dark pool due to their different level of understanding the operations, since dark pools usually do not provide information about their inner structure and the operational procedures but remain thoroughly opaque.²⁸⁶ Dark pools may favor some participants over others within the dark pool by, for instance, conveying trading information in the form of an actionable Indication of Interest (IOI) only to an exclusive group.²⁸⁷ IOIs simply contain privy information about an order in a dark pool.²⁸⁸ Consequently, the recipient may have an informational advantage which he may use not only to trade against that order but also to trade ahead of the order.²⁸⁹ The original sender of the IOI is usually not aware of the recipients with whom the dark pool shared the information and the information asymmetry resulting from this kind of disclosure prior to the trade.²⁹⁰ Moreover, as stated above, it may be costly to remain informed as this requires participation in multiple dark pools and technical capabilities to synthesize the information stemming from the different venues, which may also cause asymmetries within an individual dark pool.²⁹¹

2. Impact Due to Discretionary Access Rules The second issue concerns the impact on the market due to discretionary access rules. As the Technical Committee of the IOSCO concluded, “access to information is only of limited assistance if it is not possible to access the trading oppor-

 Mills, The Rise of the Dark Side; Dark pool trading and the two-tiered implication (June 2014), 8, 16 – 17.  IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 22; ComertonForde, Shedding light on dark trading in Europe (Aug. 2017), 6.  Boni/Brown/Leach, Dark Pool Exclusivity Matters (Dec. 19, 2013), 2; Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 346.  Batista, 14 J. High Tech. L. (2014), 83, 93; Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 345.  IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 22; O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 107.  O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 107.  Mills, The Rise of the Dark Side; Dark pool trading and the two-tiered implication (June 2014), 8.

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tunity”.²⁹² Unlike exchanges, dark venues are granted significant flexibility on how to operate their venues, including access rights.²⁹³ The access to trading venues is usually restricted to participants or members. Differences exist particularly in regard to the category of participants that are granted access. Some dark pools design their rules to limit access to buy-side institutional investors and may therefore exclude other broker-dealers and high-frequency traders.²⁹⁴ Although access restrictions may be necessary to preserve the essential function of a specific trading venue, concerns arise in regard to whether certain participants are unfairly denied access to a venue causing a disadvantage compared to those granted access.²⁹⁵ Regulators are particularly concerned about the individual requirements according to which the operators provide or restrict the access to the trading venue and are eager to ensure that access rules are based on non-discriminatory and reasonable factors.²⁹⁶ In the US, national securities exchanges have to provide fair access to potential members and prohibit them from denying access in an unreasonably discriminatory manner.²⁹⁷ Dark pools, on the other hand, are run by broker-dealers who, unlike exchanges, are not subject to the same regulatory requirements. Under Regulation ATS alternative trading venues have to provide fair access to their services only if they exceed a five percent trading volume threshold.²⁹⁸ Dark pools, however, usually operate below this threshold.²⁹⁹ Therefore, the broker-dealers provide their own discretionary access rules and control who will be granted access to the dark pool, usually through private negotiation.³⁰⁰ Similarly, in the EU, regulated markets are required to establish, implement, and maintain transparent and non-discriminatory rules regarding the access.³⁰¹

 IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 21.  Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 6.  Boni/Brown/Leach, Dark Pool Exclusivity Matters (Dec. 19, 2013), 3.  Cf. Macey/O’Hara, 28 J. Legal Stud. (1999), 17, 35 note 36; IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 21.  IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 22; Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 581.  Sec. 6(b)(2) SEA; 15 U.S.C. § 78 f(b)(2).  17 C.F.R. § 242.301(b)(5); cf. Klock, 51 Fla. L. Rev. (1999), 753 – 797, 770; Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 21.  Cf. Shorter/Miller, Dark Pools in Equity Trading: Policy Concerns and Recent Developments (Sept. 26, 2014), 7.  Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 580 – 581; SEC, Concept Release on Equity Market Structure, Proposed Rule, Release No. 61358 (Jan. 14, 2010), 75 Fed. Reg. (Jan. 21, 2010), 3594– 3614, 3614.  Art. 53 MiFID II; cf. Moloney, EU Securities and Financial Markets Regulation, 473.

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In Germany, for instance, national exchanges are generally obliged to provide access to potential members, whereas operators of MTFs and dark pools are subject to private law and may therefore restrict access on grounds of the principle of freedom of contract³⁰² Consequently, they can discourage or exclude certain traders.³⁰³ However, the rules governing the access to the trading venue must be transparent and non-discriminatory.³⁰⁴ As dark pools are opaque also in regard to their operation and internal structure and do not identify their traders, it is difficult to supervise the compliance with the fair access requirements. Hence, there is a likely risk that some traders may be discriminated and disadvantaged, and that dark trading may negatively impact market integrity and investor protection.

3. Analysis of Academic Literature Unlike the issues regarding the impact on price discovery and liquidity, the fair access issue is of mainly legal rather than economic concern. Hence, there is little empirical and theoretical data available. Further evidence, however, can be provided by previous investigations of the New York State Attorney General. Boni, Brown and Leach analyze whether dark pool exclusivity affects execution quality.³⁰⁵ They find that some dark pool exclusivity may lead to higher execution quality for large trades and thus, have a positive impact on market quality.³⁰⁶ However, they only documented evidence on a dark pool specifically designed to restrict access to buy-side institutional investors. They point out that “not all dark pools are created equal” and that their heterogeneity may lead to different results depending on their individual access rules.³⁰⁷ Despite the impact on market quality, access rules of dark pools are likely to inhibit market integrity and investor protection. Recent investigations of the New York State Attorney General revealed that some dark pool operators promote the exclusivity of their venues but in fact violate their own rules by granting access to certain participants that ought to be excluded according to their rules.³⁰⁸

 § 19(4), (5) BoersG; cf. Hammen, Boersen und multilaterale Handelssysteme im Wettbewerb (Exchanges and Multilateral Trading Systems in Competition), 71– 72.  Cf. Comerton-Forde/Putniņš, 118 J. Fin. Econ. (2015), 70, 73.  See Rec. 14 MiFID II, Art. 18(3) MiFID II.  Boni/Brown/Leach, Dark Pool Exclusivity Matters (Dec. 19, 2013), 3.  Boni/Brown/Leach, Dark Pool Exclusivity Matters (Dec. 19, 2013), 30.  Boni/Brown/Leach, Dark Pool Exclusivity Matters (Dec. 19, 2013), 30.  SEC, Press Release 2016 – 16, Barclays, Credit Suisse Charged With Dark Pool Violations, January 31, 2016, https://www.sec.gov/news/pressrelease/2016 -16.html (last visited February

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Regarding the access to information parallels can be drawn to the discussion surrounding the regulation of insider trading and legal disclosure provisions.³⁰⁹ Asymmetrical distribution of information likely harms market efficiency and may result in market failure.³¹⁰ The major issue in regard to dark trading is the use of actionable IOIs. They contain valuable information concerning the best prices and sizes for a particular financial instrument that would influence the quoted spread.³¹¹ However, the public does not have access to this information. Thus, the use of IOIs is likely to create a two-tiered level of access to information and thereby harm market efficiency and investor protection.³¹² The investigations by the New York State Attorney General also revealed that some dark pool operators failed to keep their member’s trading information confidential and leaked it to some other participants, usually high-frequency traders or affiliates who benefitted from this informational advantage.³¹³ Further, dark pool operators did not inform all their members about specific products and thus, discriminated certain members.³¹⁴ It is argued that, even though the dark sector may be open to the general public as fair access requirements largely apply, meaningful participation is too costly for the average public participant.³¹⁵ The IOSCO points out that differential access to trading information should not unfairly disadvantage specific categories of participants.³¹⁶ Thus, if a certain category of participants can de facto not afford access to information, regulators may have to intervene in order to prevent information asymmetries and to protect investors.³¹⁷

16, 2018); Supreme Court, New York County, New York, People ex rel. Schneiderman v. Barclays Capital Inc. (Feb. 13, 2015) 47 Misc.3d 862.  See for the reasons behind general disclosure provisions Brinckmann, Foundations, in: Veil, European Capital Markets Law, 263, 270 – 274.  Cf. Brinckmann, Foundations, in: Veil, European Capital Markets Law, 263, 270.  Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 346.  Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 346 – 347.  SEC, In the Matter of eBX, LLC, Release No. 67,969, File No. 3 – 15058 (Oct. 3, 2012), para. 2; SEC, In the Matter of ITG Inc. and AlterNet Securities, Inc., File No. 3 – 16742 (Aug. 12, 2015), para. 4; SEC, Press Release 2014– 114, SEC Charges New York-Based Dark Pool Operator With Failing to Safeguard Confidential Trading Information (June 6, 2014), https://www.sec.gov/news/press-re lease/2014-114 (last visited Sept. 25, 2018). See for more details Ch. 3 (B.III.).  SEC, In the Matter of UBS Securities LLC, File No. 3 – 16338 (Jan. 15, 2015), para. 3, 12 and 44– 48.  Mills, The Rise of the Dark Side; Dark pool trading and the two-tiered implication (June 2014), 51.  IOSCO, Objectives and Principles of Securities Regulation (Feb. 2008), 43.  For instance, in the US, Rule 610 is aimed to ensure equal access to quotations. It prohibits unfairly discriminatory terms that inhibit customer access and provides a cap on fees that can be

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However, regulators have to carefully distinguish between access to information and access to trading opportunities.³¹⁸ Regarding the access to trading opportunities, this is generally provided to the public by the exchanges and does not require access to dark pools.³¹⁹ In a free market economy, operators of dark pools are therefore free to choose with whom they want to contract.³²⁰ A harmful impact due to exclusivity or access restrictions is therefore rather unlikely and may only occur if access rules are discriminatory or if the operators do not comply with the access rules. There is no evidence that in regard to dark trading this is an issue per se. The issue over access is rather about access to information that is valuable to the public.³²¹ Investors without access to all lit and dark venues – typically retail investors – are worse off.³²² However, there is no general legal right or public policy justification for giving counterparties access to the valuable information contained in proprietary order flow and quotations.³²³ Thus, restricted access to information does not per se justify regulatory intervention. Rather, further empirical evidence is necessary to assess whether the informational asymmetries reach a level that harms market efficiency.

IV. Impact by Predatory Trading Strategies Investors and other market participants usually pay little attention to issues that in their mind are merely of theoretical nature, such as the impact of automated trading on market stability, unless they experience negative effects themselves. When the Dow Jones plunged USD 1 trillion in market value within half an hour during the flash crash on May 6, 2010, regulators and market participants were suddenly alarmed and realized that market stability was at risk.³²⁴ In its report the SEC and the US Commodity Futures Trading Commission (CFTC) deter-

charged by trading venues for access to quotations. See Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 23.  Macey/O’Hara, 28 J. Legal Stud. (1999), 17, 47.  Macey/O’Hara, 28 J. Legal Stud. (1999), 17, 47– 48.  Macey/O’Hara, 28 J. Legal Stud. (1999), 17, 48.  Macey/O’Hara, 28 J. Legal Stud. (1999), 17, 47– 48.  Apergis/Voliotis, 41 IRFA (2015), 101, 105.  Macey/O’Hara, 28 J. Legal Stud. (1999), 17, 48.  Lewis, Flash Boys, 82 stating that the flash crash “opened the buy side’s willingness to understand what was going on”. See also Clarke, 8 LFMR (2014), 342, 343; Prewitt, 19 MTTLR (2012), 131– 161, 133; cf. Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 479.

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mined that the sudden volatility had coincided with HFT activity.³²⁵ They concluded that the automatization of trade executions and algorithmic trading strategies are susceptible for malfunctions and can quickly erode liquidity and cause disorderly markets if they are out of control.³²⁶ However, it was not until the New York State Attorney General started to investigate into HFT practices that market participants became aware of how the financial markets had changed due to fragmentation and technological development, and that by that time almost no one actually understood what happened in the markets.³²⁷ Many investors had experienced unpleasant encounters with high-frequency traders due to manipulative and unfair trading strategies, causing financial losses and undermining their confidence in the integrity of the markets.³²⁸ As the success of many of those trading strategies – hereinafter simply summarized as predatory trading strategies – is based on the difference in speed of sending orders and executing transactions, the strategies are usually performed by high-frequency traders.³²⁹ However, not all HFT strategies are classified as predatory and, vice versa, not all predatory strategies do necessarily fall under HFT but may be employed by other aggressive traders.³³⁰ Predatory trading strategies are thus not limited to a particular category of traders.³³¹ Some of the strategies are categorized as illegal manipulation and are thus prohibited.³³² But even those strategies not classified as manipulation may under

 Prewitt, 19 MTTLR (2012), 131– 161, 132; U.S. Commodity Futures Trading Commission/SEC, Findings Regarding the Market Events of May 6, 2010 (Sept. 30, 2010), 2, 5.  U.S. Commodity Futures Trading Commission/SEC, Findings Regarding the Market Events of May 6, 2010 (Sept. 30, 2010), 6.  See Lewis, The Wolf Hunters of Wall Street (Mar. 31, 2014), https://www.nytimes.com/2014/ 04/06/magazine/flash-boys-michael-lewis.html (last visited Sept. 25, 2018); Lewis, Flash Boys, 79; cf. Clarke, 8 LFMR (2014), 342, 343 arguing that “the existence and extensive use of dark pools is an indication of how markets have become fragmented and eroded by the activities of HFT and other aggressive predatory strategies”.  Cf. Lewis, Flash Boys, 31– 34, 79; Prewitt, 19 MTTLR (2012), 131– 161, 133.  Adler, 39 Vt. L. Rev. (2014), 161– 205, 167; cf. Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 494.  See Ch. 1 (B.I.1.) for a general introduction on algorithmic trading and HFT. See for detailed classification and description Serbera/Paumard, 36 RIBAF (2016), 271 et seqq.; Kasiske WM (2014), 1933 – 1940, 1935.  Gomber/Arndt/Lutat/Uhle, High-Frequency Trading (Mar. 2011), 31.  Prewitt, 19 MTTLR (2012), 131– 161, 147 et seqq.; Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 494; Teigelack, Market Manipulation, in: Veil, European Capital Markets Law, 225, 235 – 237, 243; see for an overview of possible forms of trade-based market manipulations Art. 12 MAR (Regulation (EU) No 596/2014 of 16 April 2014 on market abuse (Market Abuse Regulation, MAR), published in Official Journal of the Eu-

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some circumstances harm other investors or risk market stability. The fine distinction between the different strategies is not always easy to make. For the following assessment, however, this is not relevant as the main purpose is to analyze the impact of dark trading in regard to certain HFT strategies and not the impact of HFT strategies as such. A general assessment of HFT strategies would therefore exceed the scope of this study.³³³ Most importantly, the ongoing investigations by the New York State Attorney General revealed that contrary to previous assumptions many of those unseemly activities took place in the dark.³³⁴ Some dark pools granted access to high-frequency traders, however, without correctly informing other participants in the pool misleading them about the presumed protection against HFT activity and shaking their confidence in the integrity of the market.³³⁵ The characteristics of dark trading – opaqueness in regard to pre-trade data about orders and traders – may attract investors who seek to pursue such improper strategies.³³⁶ More-

ropean Union, L173/1 (June 12, 2014)) and Annex II sections 1 and 2 of Commission Delegated Regulation (EU) No. 2016/522 supplementing MAR. In the US, Sec. 10(b) prohibits the use of “any manipulative or deceptive device” in connection with trading a security in contravention of rules promulgated by the SEC. However, the term ‘manipulative’ has not been further defined. See Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 27– 28.  A thorough analysis of the impact of HFT on the market is provided by, inter alia, Gomber/ Arndt/Lutat/Uhle, High-Frequency Trading (Mar. 2011), and Korsmo, 48 U. Rich. L. Rev. (2014), 523 – 609.  Neate, Barclays and Credit Suisse pay biggest ever fines for dark pool trading (Jan. 31, 2016), https://www.theguardian.com/business/2016/jan/31/barclays-and-credit-suisse-to-paybiggest-ever-fines-for-dark-pool-trading (last visited Sept. 25, 2018); SEC, Press Release 2016 – 16, Barclays, Credit Suisse Charged With Dark Pool Violations (Jan. 31, 2016), https://www.sec.gov/ news/pressrelease/2016 -16.html (last visited Sept. 25, 2018).  Barclays, for example, was alleged of, among others, (1) falsifying marketing materials purporting to show the extent and type of HFT in its dark pool, which intentionally excluded the dark pool’s then largest participant, a HFT firm Barclays knew engaged in predatory behavior in the dark pool; (2) falsely marketing the percentage of aggressive HFT activity in its dark pool; (3) falsely representing to clients that the system analyzed each interaction in the dark pool to “protect clients from predatory trading” when in reality it failed to remove or profile predatory traders; (4) secretly giving HFT firms informational and other advantages over other clients, allowing them to maximize the effectiveness of their aggressive trading strategies, while marketing the dark pool to institutional investors as offering protection from HFT. See the complaint filed by the NY AG The People of the State of New York by Eric t. Schneiderman, Attorney General of the State of New York, Complaint against Barclays Capital Inc., and Barclays PLC (June 25, 2014), 2 et seqq.  Shorter/Miller, Dark Pools in Equity Trading: Policy Concerns and Recent Developments (Sept. 26, 2014), 7.

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over, due to the speed of trading and the complexity of the algorithms, it is rather difficult to recognize the patterns and detect predatory trading strategies.³³⁷ However, it is a bit ironic that those now allegedly benefitting from dark trading once were the main reason why dark trading boomed in the first place. As discussed in Chapter 1 (B.I.1.) high-frequency traders caused disadvantages for other traders who could not keep up with the speed and hence suffered significant losses. When recalling the main incentives for dark trading it becomes clear that investors who trade in the dark usually have one interest in common: getting a better price – either by avoiding a price movement of the market price or by minimizing trading costs.³³⁸ This interest is threatened by HFT and therefore, institutional investors seek to avoid any interactions with high-frequency traders. Public exchanges, however, allow HFT and due to comprehensive transparency requirements, institutional traders are completely at the mercy of highfrequency traders. Picking up this urgent need for protection from HFT and unlimited transparency, dark pools supposedly offer a “lifeline” and attractive alternative. Whereas institutional investors want to hide their buying or selling interest and therefore, use dark pools to prevent their orders from being detected, other traders, in particular high-frequency traders, want to discover this hidden liquidity in the expectation of making a profit by using certain strategies and therefore, also seek to enter the dark sector.³³⁹ Although the issue is not directly linked to dark trading, concerns are raised that dark trading may facilitate improper trading strategies.³⁴⁰ The main indication for this concern is that high-frequency traders are usually considered to be modern market makers and hence, provide liquidity.³⁴¹ As previously stated, market fragmentation led to increased competition among trading venues for order flow and thus, for liquidity. If a venue lacks liquidity, some traders may be deterred to trade on that venue. Less trading means less liquidity, which eventually leads to a decrease in profit. Dark pools in particular may struggle with this depending on their size. If a dark pool has only a limited number of partic-

 Prewitt, 19 MTTLR (2012), 131– 161, 147.  Cf. Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 35.  Cf. Coffee/Sale/Henderson, Securities Regulation, 622– 623.  Kasiske WM (2014), 1933 – 1940, 1938.  Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 37, 39 – 40; cf. Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 489, 496.

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ipants, liquidity is rather low as is the execution probability.³⁴² In order to attract more participants, however, they need to provide more liquidity first. This creates the tension: because high-frequency traders act as market makers providing liquidity³⁴³, dark pool operators are inclined to grant access to some high-frequency traders to get more trades executed in the pool. Consequently, dark pools entail the inherent risk to harm investor protection, market integrity and market stability by enabling traders to successfully adopt predatory trading strategies without being detected.

1. Predatory Trading Strategies There are different types of HFT and other algorithmic strategies which can further be divided into “neutral” strategies and “predatory” strategies.³⁴⁴ The following assessment does not include general HFT strategies as such but focuses solely on individual trading strategies of the second category that are linked to dark trading, for instance, because they are easier to pursue in the dark. Although most of these strategies have been employed before, new technologies and, in particular, HFT algorithms enabled traders to successfully implement these strategies and make them more profitable.³⁴⁵ The traders seek to create an unlevel playing field and to profit from the technological advantage. The main objective behind predatory trading strategies in the dark is to detect hidden liquidity and price discrepancies, and, if there is nothing to detect, to generate liquidity and price movements by all means.³⁴⁶ Hence, these strategies can be divided into two broad categories: (1) strategies aimed at exploiting price discrepancies by taking advantage of speed (including pinging, electronic frontrunning, quote stuffing); (2) strategies aimed at causing price movements to influence the price in the trader’s own favor (including spoofing, layering, momentum ignition).

 Adler, 39 Vt. L. Rev. (2014), 161– 205, 175.  A certain strategy of high-frequency traders is to act as liquidity providers. See for details Gomber/Arndt/Lutat/Uhle, High-Frequency Trading (Mar. 2011), 25; Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 495.  Cf. Korsmo, 48 U. Rich. L. Rev. (2014), 523 – 609, 546. See for a more general overview: Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 484– 489; Teigelack, Market Manipulation, in: Veil, European Capital Markets Law, 225, 235 – 241, 243. For further details see Adler, 39 Vt. L. Rev. (2014), 161– 205; Gomber/Arndt/Lutat/ Uhle, High-Frequency Trading (Mar. 2011), 21– 31.  Gomber/Arndt/Lutat/Uhle, High-Frequency Trading (Mar. 2011), 24, 31.  Cf. Korsmo, 48 U. Rich. L. Rev. (2014), 523 – 609, 546 – 548.

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a. Strategies to Exploit Price Discrepancies The first category is aimed at exploiting price discrepancies by taking advantage of speed. Therefore, traders need to first detect hidden liquidity in the dark. In order to do so, traders, usually high-frequency traders, apply a strategy called “pinging”, whereby they send very small orders to a dark pool at the midpoint of the spread for a security.³⁴⁷ If these orders are immediately accepted, it implies that there is hidden liquidity, i. e. a large order, and the traders can automatically adjust their algorithms.³⁴⁸ Once the high-frequency trader has detected the hidden liquidity his next goal is to use this advantage to achieve price benefits or make a profit. In this context, a popular strategy is “latency arbitrage”, commonly known as “electronic front-running”.³⁴⁹ General arbitrage is “the attempt to profit from a situation where the same goods are selling for different prices at the same time, by buying at the lower price and selling at the higher price”.³⁵⁰ Due to market fragmentation, most of the securities are currently traded on several venues at the same time. Although the market aims to provide market-driven prices reflecting supply and demand, the prices may differ within a short period of time until the new information is implemented in the price. Thus, any price discrepancy represents an arbitrage opportunity providing an appealing source of profit for those able to discover the discrepancies.³⁵¹ In the case of electronic front-running, the trader front-runs an order by detecting buy and sell orders of large institutional investors and trading accordingly.³⁵² Namely, the trader front-running the other orders executes the trade before the large investor can complete the trade, thereby causing the price to move in favor of himself and against the institutional investor.³⁵³ After the price movement the trader turns around, places the orders and executes them at the better

 Coffee/Sale/Henderson, Securities Regulation, 623.  Coffee/Sale/Henderson, Securities Regulation, 623; Biedermann, 1 Public Finance Quarterly (2015), 78, 81; Teigelack, Market Manipulation, in: Veil, European Capital Markets Law, 225, 237 referring to pinging as ‘phishing’.  Cf. Coffee/Sale/Henderson, Securities Regulation, 620.  Korsmo, 48 U. Rich. L. Rev. (2014), 523 – 609, 545 referring to SEC, Concept Release on Equity Market Structure, Proposed Rule, Release No. 61358 (Jan. 14, 2010), 75 Fed. Reg. (Jan. 21, 2010), 3594– 3614, 3608 (“An arbitrage strategy seeks to capture pricing inefficiencies between related products or markets.”).  Korsmo, 48 U. Rich. L. Rev. (2014), 523 – 609, 545.  Zaza, 18 Stan. J.L. Bus. & Fin. (2013), 319, 322; Fox, MiFID II and Equity Trading: A US View, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 18.01– 18.127, 18.42; Shorter/Miller, Dark Pools in Equity Trading: Policy Concerns and Recent Developments (Sept. 26, 2014), 7.  Zyskind, 91 Chicago-Kent L. Rev. (2016), 411, 416.

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price profiting from the arbitrage.³⁵⁴ The trader may either trade on the same venue, even with the same institutional investor that he front-runs, or on another venue.³⁵⁵ Fascinatingly, this all happens within a fraction of a second. The institutional investor will usually only recognize the price change to his detriment and may not have an explanation for what happened.³⁵⁶ Of course, this strategy requires enormous speed and thus, can only be pursued by high-frequency traders using co-location services, private data feeds, and special algorithms.³⁵⁷ Electronic front-running is sometimes considered unfair because the highfrequency trader benefits from the ability to get earlier knowledge and to trade almost instantaneously to the detriment of other traders, usually institutional traders.³⁵⁸ However, whether or not this strategy falls under the category of illegal market manipulation depends on the circumstances.³⁵⁹ There may be cases in which the high-frequency trader unfairly obtains leaked information which he uses to pursue front-running.³⁶⁰ One method to gain such an informational advantage is so-called ‘flash trading’ by sending flash orders to the market to discover price movements before entering an order.³⁶¹ Flash orders are orders that are exempt from being included in the consolidated quotation data as they only occur within the fraction of a second and must immediately be either executed or cancelled.³⁶² Hence, they can be communicated to selected market participants and not to the entire market creating a two-tiered market.³⁶³ This could constitute a case of market manipulation. However, even if a certain strategy does not fall under the category of market manipulation, HFT in general is

 Kasiske BKR (2015), 454, 456; Coffee/Sale/Henderson, Securities Regulation, 620.  Cf. Fox, MiFID II and Equity Trading: A US View, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 18.01– 18.127, 18.42 using the example of front-running across different venues. Shorter/Miller, Dark Pools in Equity Trading: Policy Concerns and Recent Developments (Sept. 26, 2014), 7 explaining front-running happing within one market.  Lewis, Flash Boys, 53.  Ch. 1 (B.I.1., 2.) outlines the different advantages making HFT successful.  See for the general discussion Coffee/Sale/Henderson, Securities Regulation, 620.  Shorter/Miller, Dark Pools in Equity Trading: Policy Concerns and Recent Developments (Sept. 26, 2014), 7; Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 41.  Cf. Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 331.  Hazen, Treatise on the law of securities regulation: Volume 5, 244; Coffee/Sale/Henderson, Securities Regulation, 620; Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 487.  Coffee/Sale/Henderson, Securities Regulation, 621; Lerch, Algorithmic Trading and HighFrequency Trading, in: Veil, European Capital Markets Law, 477, 487.  Coffee/Sale/Henderson, Securities Regulation, 621; Lerch, Algorithmic Trading and HighFrequency Trading, in: Veil, European Capital Markets Law, 477, 495.

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often considered to be unfair because of the advantages high-frequency traders gain over other traders.³⁶⁴ Proponents of HFT, on the other hand, argue that HFT may even provide benefits, at least for some investors, for instance by lowering bid-offer spreads and reducing transaction costs.³⁶⁵ Making an arbitrage profit requires latency in the distribution of information between different trading venues. New technologies, however, enable a decrease in latency, thereby challenging and hampering HFT strategies such as front-running. Thus, high-frequency traders sought for another way to create more speed advantage and invented quote stuffing. Using this strategy traders send huge numbers of orders and almost immediate cancellations in a rapid succession to a trading venue with the purpose to slow down the market and provide the manipulating trader with a speed advantage.³⁶⁶ The enormous number of orders overloads the computer systems and slows down the processing of the incoming orders.³⁶⁷ Hence, the trader creates an artificial latency providing an arbitrage opportunity as the prices do not include the new orders and hence, do not reflect the actual value.³⁶⁸

b. Strategies to Influence the Prices Whereas the previous mentioned strategies do not directly manipulate the prices but may also improve the prices by narrowing the spreads, other strategies are directly aimed at influencing the prices in favor of the respective trader. Because prices adjust to demand and supply, price movements can be caused intentionally by sending “fictitious or disingenuous” market orders.³⁶⁹ Strategies used for this purpose include, among others, (1) spoofing, (2) layering and (3) momentum ignition.

 Cf. Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 495.  Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 496; cf. Fox, MiFID II and Equity Trading: A US View, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 18.01– 18.127, 18.50 – 18.61; Gomber/Arndt/Lutat/Uhle, High-Frequency Trading (Mar. 2011), 2, 6.  Adler, 39 Vt. L. Rev. (2014), 161– 205, 172– 173; Korsmo, 48 U. Rich. L. Rev. (2014), 523 – 609, 575; Clarke, 8 LFMR (2014), 342, 347.  Adler, 39 Vt. L. Rev. (2014), 161– 205, 173; Kasiske WM (2014), 1933 – 1940, 1936.  Korsmo, 48 U. Rich. L. Rev. (2014), 523 – 609, 575; Adler, 39 Vt. L. Rev. (2014), 161– 205, 173; Kasiske WM (2014), 1933 – 1940, 1936.  Adler, 39 Vt. L. Rev. (2014), 161– 205, 171.

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Spoofing is a strategy by which a trader submits multiple or large orders to buy or sell with no intention of executing them.³⁷⁰ The trader thereby creates the impression of high demand or supply, which is actually incorrect since the trader does not intend to get the orders filled.³⁷¹ As demand or supply increases, the securities prices change. Expecting other traders to submit orders due to the increased liquidity, the trader enters into a transaction at the better price and cancels all the misleading orders before executing them.³⁷² The strategy can also be used to manipulate the reference price used for dark trading by placing a limit order on the public exchange which will then influence the reference price in favor of the trader. Once the trade is executed in the dark sector at the manipulated reference price, the order on the public exchange is cancelled instantaneously.³⁷³ Layering is another form of spoofing whereby the trader sends multiple limit orders to the market in very short intervals in order to create the misleading impression of a certain price development to attract other traders.³⁷⁴ Once the limit is reached the trader can either execute the order or cancel it.³⁷⁵ Momentum ignition is a strategy aimed at artificially creating a market trend to influence the trading behavior of a number of traders in order to ultimately achieve the desired trend and influence the market price.³⁷⁶ A high-frequency trader pursuing this strategy would, for instance, send “mock orders” to create the impression of a certain market trend, e. g. price increase, and then wait for other multiple traders to trade until the price actually increases so that he can sell at this higher price to make a profit.³⁷⁷ The strategy works similarly to spoofing and layering, but unlike those strategies, the trader uses momentum ignition not only to create a temporarily price movement for a certain transaction but to actually change a security’s price in his favor.³⁷⁸

 Teigelack, Market Manipulation, in: Veil, European Capital Markets Law, 225, 237; Kasiske WM (2014), 1933 – 1940, 1937.  Teigelack, Market Manipulation, in: Veil, European Capital Markets Law, 225, 237; Kasiske WM (2014), 1933 – 1940, 1937.  Teigelack, Market Manipulation, in: Veil, European Capital Markets Law, 225, 237; Clarke, 8 LFMR (2014), 342, 347.  Kasiske BKR (2015), 454, 457– 458.  Kasiske WM (2014), 1933 – 1940, 1937.  Kasiske WM (2014), 1933 – 1940, 1938.  Teigelack, Market Manipulation, in: Veil, European Capital Markets Law, 225, 237; Kasiske WM (2014), 1933 – 1940, 1938; SEC, Concept Release on Equity Market Structure, Proposed Rule, Release No. 61358 (Jan. 14, 2010), 75 Fed. Reg. (Jan. 21, 2010), 3594– 3614, 3609.  Kasiske WM (2014), 1933 – 1940, 1936.  Kasiske WM (2014), 1933 – 1940, 1938; Adler, 39 Vt. L. Rev. (2014), 161– 205, 171– 172.

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Regulators, both in the US and the EU, have already taken steps to prohibit these kinds of strategies and classified them as illegal market manipulation.³⁷⁹

2. Impact due to Lack of Transparency and Supervision While for the underlying purpose it is not relevant whether a specific strategy constitutes illegal market manipulation or whether it is actually harmful for other reasons, the remaining substantial issue is whether dark trading in particular facilitates certain trading strategies, thereby harming the market and market participants. There are two characteristics of dark trading which may ease the undetected implementation of predatory trading strategies: (1) the lack of transparency, and (2) the lack of supervision. Dark pools characteristically lack pre-trade transparency and provide hidden liquidity. On the one hand, they attract traders who seek to hide their orders and to avoid information leakage, on the other hand, they consequently also attract traders who seek to use strategies to detect those hidden orders before others do.³⁸⁰ Moreover, due to immense variety of trading venues and the increased competition for order flow, dark pools experience difficulties finding counterparties for their customers.³⁸¹ This creates a dangerous tension. As high-frequency traders are seen as “the new liquidity providers”³⁸², dark pools may be tempted to grant them access if liquidity is low. Further, high-frequency traders are willing to pay large sums for co-location services and special data feeds – a source of revenue that should not be underestimated.³⁸³ Dark venues have great flexibility on how to operate their venues and can implement operational rules which allow them to reject and exclude certain orders or traders.³⁸⁴ As different types of orders are attractive to different types of traders, dark pools can control the access and interaction of certain groups of

 Busch, 10 LFMR (2016), 72; see SEC, Concept Release on Equity Market Structure, Proposed Rule, Release No. 61358 (Jan. 14, 2010), 75 Fed. Reg. (Jan. 21, 2010), 3594– 3614, 3609; Teigelack, Market Manipulation, in: Veil, European Capital Markets Law, 225, 235 – 237, 243; Art. 12 MAR, Annex II sections 1 and 2 of Commission Delegated Regulation (EU) No. 2016/522 supplement MAR.  O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 103.  Batista, 14 J. High Tech. L. (2014), 83, 93.  Coffee/Sale/Henderson, Securities Regulation, 619 – 620.  Cf. Coffee/Sale/Henderson, Securities Regulation, 622; Lerch, Algorithmic Trading and HighFrequency Trading, in: Veil, European Capital Markets Law, 477, 487.  Cf. Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 40; Coffee/Sale/Henderson, Securities Regulation, 622; Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 6.

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participants by customizing their services accordingly.³⁸⁵ This may in fact inhibit HFT from entering the dark pool and attract institutional investors who seek to avoid any interaction with HFT and hide their orders.³⁸⁶ However, the investigations by the New York State Attorney General show that theory does not always prevail in practice and that dark pools seem to have reasons to privily grant access to high-frequency traders and accept their orders knowing that this would facilitate the use of predatory trading strategies.³⁸⁷ This issue would not be as important if those unseemly practices could be easily detected and if the compliance of dark pools with their own operational rules would be better supervised and violations be prosecuted. However, dark venues lack operational transparency as the disclosure requirements about the venue operation are relatively low.³⁸⁸ They do not publish their rules and thus, outsiders are not aware of what is happening inside the dark venues.³⁸⁹ But even if dark venues would be more transparent in this regard, regulators would hardly be able to detect predatory trading strategies due to the speed of the trades and the complexity of the algorithms.³⁹⁰ Whether HFT is pursued on lit venues or dark venues does not matter as long as regulatory lack the tools to effectively monitor HFT.³⁹¹

3. Analysis of Academic Literature According to the SEC’s summary in its Equity Market Structure Literature Review on high-frequency trading, the significant use of order anticipation strategies by high-frequency traders undermines the incentives of other traders to do fundamental research to gain valuable information as the HFT algorithm would cap-

 Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 40.  Coffee/Sale/Henderson, Securities Regulation, 622.  SEC, Press Release 2016 – 16, Barclays, Credit Suisse Charged With Dark Pool Violations (Jan. 31, 2016), https://www.sec.gov/news/pressrelease/2016 -16.html (last visited Sept. 25, 2018); Neate, Barclays and Credit Suisse pay biggest ever fines for dark pool trading (Jan. 31, 2016), https://www.theguardian.com/business/2016/jan/31/barclays-and-credit-suisse-to-paybiggest-ever-fines-for-dark-pool-trading (last visited Sept. 25, 2018).  Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 6.  Lewis, Flash Boys, 86. “It was entirely possible that a broker’s own traders were trading against the customers in the dark pool: There were no rules against it.”  Prewitt, 19 MTTLR (2012), 131– 161, 147, 155. Cf. Lewis, Flash Boys, 81. “[N]o one could prove that high-frequency traders were front-running the orders of ordinary investors. The data didn’t exist.”  Prewitt, 19 MTTLR (2012), 131– 161, 147.

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ture this information, leading to an overall decline in the production of fundamental information.³⁹² Consistent with these findings, it is likely that due to the lack of transparency dark trading facilitates the use of those trading strategies, thereby undermining the investors’ trust in market integrity and investor protection, and hence, eventually undermining their incentives to trade. This result negatively affects market integrity and market efficiency. Further, dark trading could indirectly threaten investor protection as predatory strategies can harm investors if they could have made a better deal without the high-frequency trader’s intervention.³⁹³ The FCA, for instance, finds that high-frequency traders make profits by using aggressive market orders at the expense of other participants.³⁹⁴ Detrimental effects are caused, in particular, if dark venues use stale reference prices that do not match the current midpoint of the NBBO/BBO at the public exchange, or, more general, execute at prices inferior to other prices available.³⁹⁵ Consequently, high-frequency traders can benefit due to latency arbitrage, by taking advantage of the price difference between dark and lit venues at this time.³⁹⁶ Consistently, Brunnermeier and Pedersen find that predatory trading leads to “price overshooting” and amplifies liquidation cost of other traders.³⁹⁷ However, further empirical analysis is necessary to evaluate whether the losses or additional costs incurred to other investors are actually harmful.³⁹⁸ Brunnermeier and Pedersen also argue that dark trading may indirectly have a negative effect

 SEC Division of Trading and Markets, Equity Market Structure Literature Review – Part II: High Frequency Trading (Mar. 18, 2014), 31 referring to Hirschey, Do High-Frequency Traders Anticipate Buying and Selling Pressure? (2013), https://papers.ssrn.com/sol3/papers.cfm?abstract_ id=2238516 (last visited Sept. 25, 2018).  Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477 stating that non-high-frequency traders may suffer from worse prices at which their orders are executed when HFT firms are active in the market.  Financial Conduct Authority, Asymmetries in Dark Pool References Prices (Sept. 2016), 25.  Financial Conduct Authority, Asymmetries in Dark Pool References Prices (Sept. 2016), 4 finding that the proportion of all dark midpoint trades referencing a stale price was increasing over time, from 3.36 % in 2014 to 4.05 % in June 2015.  Financial Conduct Authority, Asymmetries in Dark Pool References Prices (Sept. 2016), 25 finding that HFT participants are on the profitable side of stale trades 96 % of the time while co-located participants are on the losing side 88 % of the time, and non co-located 91 % of the time.  Brunnermeier/Pedersen, 60 J. Finance (2005), 1825, 1852.  In regard to aggressive HFT trading, Baron, Brogaard, Hagströmer and Kirilenko find that the cost of the HFT industry incurred to other investors is not higher than the typical exchange taker fee. See Baron/Brogaard/Hagströmer/Kirilenko, Risk and Return in High-Frequency Trading (Nov. 14, 2017), 36. Similar results could be found in regard to predatory trading.

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on market stability as predatory trading practices enhance systemic risk, because of the interconnectedness of modern markets disruptions in one venue or market may spill over and trigger a crisis for the whole financial sector even global wide.³⁹⁹ This argument is also supported by Lerch, ⁴⁰⁰ Fleckner ⁴⁰¹ and Prewitt ⁴⁰² stating that algorithmic trading in general can impose systemic risks and have a harmful impact on the functioning of the financial markets as demonstrated by the flash crash in 2010 and similar events. Moreover, price manipulation can have far reaching consequences as prices are used for accounting and tax purposes.⁴⁰³ These findings purporting a harmful effect of HFT contradict with findings indicating that HFT provides benefits to the securities market and the participants. Gomber, Arndt, Lutat and Uhle for instance, find that HFT decreases volatility in the short-term and enhances market liquidity, thereby increasing market efficiency and market quality.⁴⁰⁴ Similarly, Prewitt also concludes that under normal trading conditions, HFT provides liquidity, narrows spreads, and causes beneficial price movements.⁴⁰⁵ However, according to Prewitt, empirical evidence does not demonstrate that these benefits are substantial and can outweigh the harmful effects.⁴⁰⁶ Regulators will therefore have to make a careful risk-benefit analysis before taking further steps.⁴⁰⁷ Moreover, any restrictions on dark trading in this regard will not combat the actual cause of this issue. On the contrary, dark trading is also still purported to protect investors from HFT strategies in the lit sector and thus, to minimize market manipulation in the long run.⁴⁰⁸ As previously pointed out, the major issue is that regulators have difficulty detecting and mon Brunnermeier/Pedersen, 60 J. Finance (2005), 1825, 1852.  Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 490 – 491.  Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 622.  Prewitt, 19 MTTLR (2012), 131– 161, 160.  Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 603. See for more details the previous section about price discovery (B.I.1.).  Gomber/Arndt/Lutat/Uhle, High-Frequency Trading (Mar. 2011), 33, 37. They also refer to other academic literature concluding that the majority discovers positive effects of HFT on liquidity and volatility.  Prewitt, 19 MTTLR (2012), 131– 161, 160.  Prewitt, 19 MTTLR (2012), 131– 161, 160.  Cf. Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 497– 498.  Cf. Adler, 39 Vt. L. Rev. (2014), 161– 205, 200.

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itoring predatory trading strategies, irrespective of whether they are pursued on a lit venue or dark venue.⁴⁰⁹ Therefore, regulators should first address HFT and predatory trading strategies, rather than restricting dark trading.⁴¹⁰ Besides enhancing the risks and benefits of HFT, dark trading can also have a direct impact on the market. If the predatory strategies constitute prohibited market manipulation or illegal conduct, then dark venues may incite or aid high-frequency traders to pursue these strategies and therefore, may themselves commit a violation of the law. The recent actions brought against famous dark pools sugget the likelihood that dark pools mislead traders about the appearance and the extent of HFT in order to attract institutional investors.⁴¹¹ This can have negative effects on market integrity and investor protection. Regulators may address this issue by enhancing supervision and enforcement. So far, there is only little academic research dealing with the lack of supervision and enforcement and its impact on the market. However, if further investigations reveal that this threat prevails, investors may entirely lose confidence and be deterred from trading in the dark sector. This will, in turn, harm the business model of dark pools so that, at least in the long run, their operators will likely take steps to prevent misconduct by means of self-regulation.

C. Conclusion to Chapter 2 The previous literature review is intended to shed some light on the vast amount of different, complex studies examining the issues raised by dark trading and to provide a decent overview of the major findings and conclusions. The final part of this chapter summarizes the main conclusions in order to identify those issues that accordingly may require and justify regulatory intervention and determine the relevant aspects that ought to be taken into consideration by the regulators. A table with a detailed overview of the studies and the individual conclusions considered in the literature review is provided in the Appendix to this study.

 Prewitt, 19 MTTLR (2012), 131– 161, 147, 155.  Prewitt, 19 MTTLR (2012), 131– 161, 161 suggesting to introduce strict order cancellation taxes or resting rules to reduce systemic risk and diminish opportunities for market abuse.  See SEC, Press Release 2016 – 16, Barclays, Credit Suisse Charged With Dark Pool Violations (Jan. 31, 2016), https://www.sec.gov/news/pressrelease/2016 -16.html (last visited Sept. 25, 2018); Neate, Barclays and Credit Suisse pay biggest ever fines for dark pool trading (Jan. 31, 2016), https://www.theguardian.com/business/2016/jan/31/barclays-and-credit-suisse-to-pay-biggestever-fines-for-dark-pool-trading (last visited Sept. 25, 2018).

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Overall, the literature review presents a varied picture of the effects of dark trading on the market. This may be due to a variety of factors, such as the lack of empirical data from the dark sector, the different models used in theoretical studies or the different market structures.⁴¹² Although in theory all the issues addressed support the assertion that dark trading harms the market, the analyses in the academic literature provide evidence that dark trading can be beneficial, at least to some extent. It also has a positive impact on the securities market and its participants, although other factors have to be taken into account, including the type of dark trading, the level of liquidity and the market capitalization of a specific financial instrument. The main conclusions regarding the issues addressed in the literature review can be summarized as follows. With respect to the first issue, the lack of transparency and the impact on price discovery, researchers found no consistent evidence proving that the lack of pre-trade transparency adversely affects price discovery to an extent that causes actual harm to market quality. However, dark trading does lead to partial segmentation of traders, resulting in a disproportionate dissemination of uninformed traders in the dark and informed traders in the lit market. While the economic results disagree on whether the segmentation harms price discovery, they largely agree that a high level of dark trading exceeding a certain threshold adversely affects price discovery and market quality. This threshold depends on the type of dark trading and the market capitalization of the financial instrument. Regarding the impact of dark fragmentation, researchers found that it leads to a shift of liquidity from the lit market to the dark market, which likely increases trading costs and adverse selection risk. However, given the positive effects of fragmentation on competition and the increase of order flow, the negative effects may be outweighed by those benefits. The economic results provide evidence that the negative effects have an overall harmful impact if dark trading exceeds a certain threshold, which may differ among the markets based on the level of fragmentation. Further, given the current development of dark fragmentation and the noteworthy market share of dark trading, regulators should revise the calculation of trading volumes that are relevant for the listing in stock market indices. In regard to the third issue, there is no clear evidence that access restrictions in the dark sector have a harmful impact on the market. The public has access to sufficient trading opportunities on the lit venues and regulators have already im-

 See above the “categorization of literature” (A.I.).

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posed rules on fair and non-discriminatory access for dark trading venues. Moreover, some researchers found that dark pool exclusivity may lead to higher execution quality for large trades, and thus have a positive impact on market quality.⁴¹³ However, due to the lack of transparency, the public has only limited or no access to valuable information in the dark sector. Access to information does not per se justify regulatory intervention, but a high level of dark trading can cause informational asymmetries to an extent that harms market efficiency. However, this requires further empirical evidence. Finally, there is proof that dark trading may facilitate the practice of predatory trading strategies which harms market integrity and investor protection. However, this issue is only indirectly related to dark trading as those strategies are pursued by other traders, mainly high-frequency traders. The underlying issue is actually one of lack of supervision and enforcement, which exists notwithstanding the dark nature of the venue, as regulators have difficulty detecting and monitoring predatory trading strategies, whether they are pursued on a lit venue or dark venue. Although there is not enough evidence about the market impact, theory suggests that operators of dark venues will likely prevent negative effects by means of self-regulation. Therefore, regulators should be careful when imposing restrictions on dark trading, as they may not be justified, and instead address HFT and predatory trading strategies first by enhancing supervision and enforcement. Following the empirical results and conclusions in the academic literature, regulators should address (1) transparency of dark venues, (2) market fragmentation, (3) informational asymmetries and (4) supervision in regard to predatory trading strategies and HFT. Given the positive impact and the benefits for traders, including narrower spreads, more depth, and lower volatility,⁴¹⁴ as well as lower risk of information leakage and reduced market impact costs,⁴¹⁵ any kind of regulatory intervention requires a careful cost-benefit analysis. In particular, regulators have to take into account: (1) the level of market share of dark trading, (2) the type of dark trading, (3) the market capitalization of the relevant securities, (4) the market structure and the level of market fragmentation, and (5) the influence of HFT on the effects of dark trading.

 Boni/Brown/Leach, Dark Pool Exclusivity Matters (Dec. 19, 2013), 30.  Buti/Rindi/Werner, Diving Into Dark Pools (Nov. 17, 2011), 28.  Cf. Financial Conduct Authority, TR16/5: UK equity market dark pools – Role, promotion and oversight in wholesale markets (July 2016), 8.

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First, the amount of dark trading is relevant as the results in the academic literature show that dark trading may be harmful only if it exceeds a certain threshold. Thus, imposing restrictions to simply decrease the amount of dark trading or even banning it completely, as the most rigorous form of regulatory intervention, would not sufficiently account for the benefits of dark trading and could lead to a deterioration of market quality and market efficiency.⁴¹⁶ The relevant threshold may differ among the markets depending on the type of dark trading and the market capitalization of the relevant financial instruments as well as the overall market structure and the level of market fragmentation. Thus, regulatory intervention may require further specific empirical data to determine the exact threshold for each market. The developments and changes in market structure, especially the increasing fragmentation, also caused changing dynamics of market participants. This is another reason for the overall growth in market share of the dark sector.⁴¹⁷ In this regard, it is important to consider that different investors have different needs, and that the various trading venues are able to satisfy these divergent needs.⁴¹⁸ Given the benefits dark trading venues offer to traders, in particular institutional investors, the amount of dark trading is likely to increase as long as those benefits are higher than the costs of execution risk.⁴¹⁹ Although dark venues are likely to cause a segmentation of traders by attracting more uninformed order flow from the lit markets, restricting dark trading would not sufficiently address the main cause, because the issue is a consequence of the increasing fragmentation. Market fragmentation is currently at a level unseen before and therefore, requires regulatory intervention.⁴²⁰ However, fragmentation is a side effect of facilitating competition and thus, any regulatory intervention will be a trade-off between the harms of fragmentation and the benefits of competition. Another important factor to take into consideration is HFT. As some researchers have pointed out, many issues are erroneously associated with dark trading that are mainly caused by HFT and predatory trading strategies. They

 Cf. Buchanan/Tse/Vincent/Lin et al., Measuring Dark Pools’ Impact (Jan. 31, 2011), 8. See Comerton-Forde/Putniņš, 118 J. Fin. Econ. (2015), 70, 90 recommending to consider differences in regard to individual stocks and types of dark trading.  Mills, The Rise of the Dark Side; Dark pool trading and the two-tiered implication (June 2014), 9.  Cf. Gadinis, 3 Va. L. & Bus. Rev. (2008), 311– 356, 329.  Cf. Zhu, 27 RFS (2014), 747, 761.  Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 628.

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therefore cannot be solved solely by imposing stricter regulations on dark trading. Moreover, dark trading is also still purported to protect investors from HFT strategies in the lit sector and thus, to minimize market manipulation in the long run.⁴²¹ As previously pointed out, the major issue is that regulators have difficulty detecting and monitoring predatory trading strategies, irrespective of whether they are pursued on a lit venue or dark venue.⁴²² Therefore, in order to combat the actual cause of the issue and to reduce the incentives for dark trading, regulators should first address HFT and predatory trading strategies, rather than directly restricting dark trading.⁴²³ Overall, the assessment of the impact of dark trading provides evidence that dark trading is not harmful per se but correlates with several other factors. As long as the negative effects do not outweigh the positive effects, a strict prohibition cannot be justified. Rather, regulators should address the individual issues that prove to be of real concern and base their intervention on a sufficient costbenefit analysis. The next chapter outlines the regulatory approaches of the US system and the EU system and analyzes if and how the current regulatory regimes address the issues raised by dark trading, as established in this chapter.

 Cf. Adler, 39 Vt. L. Rev. (2014), 161– 205, 200.  Prewitt, 19 MTTLR (2012), 131– 161, 147, 155.  Prewitt, 19 MTTLR (2012), 131– 161, 161 suggesting to introduce strict order cancellation taxes or resting rules to reduce systemic risk and diminish opportunities for market abuse. See also Batista, 14 J. High Tech. L. (2014), 83, 87 arguing that in order to “achieve some meaningful changes to the market, the SEC should focus on controlling the predatory behavior by the HFT firms.” According to Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 571, “there is insufficient evidence that dark pools are hurting the market place, and the SEC should continue to focus on increasing competition and access in a fair and open market.”

Chapter 3 Regulatory Approaches of Different Legal Systems Regulating the securities markets is a difficult challenge. Although the primary goals are easy to define, the achievement of these goals is not easy. Notwithstanding the divergent interests regulators have to serve, they usually lack specific expertise to make an appropriate judgement without relying on industry insiders and market participants.¹ However, as demonstrated in Chapter 2, the impact of dark trading on the market is not entirely clear and academic researchers and market participants are heavily divided on the regulation of dark trading.² This in turn makes it extremely difficult for regulators to correctly weigh the arguments of both sides and find a solution to achieve the primary regulatory goals. Implementing structural changes usually involves high costs and a legislative process that may not be able to keep pace with technological developments. Thus, the regulatory approach is significantly important for a successful regulation. In modern securities markets, several types of regulation exist and collaborate, for example: (1) governmental regulation, (2) regulation by industry or federation of venue and self-regulatory organizations (SROs), (3) self-regulation (e. g. by individual investment firms by means of corporate responsibility), (4) regulation by venue (such as the NYSE).³ Spreading regulatory power across multiple bodies has the advantage that issues can often be solved more efficiently and more effectively.⁴ For instance, successful regulation of trading venues and trading practices requires practical experience and technical expertise, something that the government usually lacks and that can be contributed by the industry.⁵ Only those actually working “on the inside” can evaluate the issues and assess the effect of certain solutions. Despite the practical input, regulations by the industry and market participants may also be more accepted since they seem to be less driven by political motives and rather by real concerns of those subject to the regulations. Moreover, the legislative process of governmen Rühl-Wolfe, 7 Nw. Interdisc. L. Rev. (2014), 327– 362, 349.  Rühl-Wolfe, 7 Nw. Interdisc. L. Rev. (2014), 327– 362, 348 – 350.  Cf. Cooper/Davis/van Vliet, 26 Bus. Ethics Q. (2016), 1, 2; Walla, Process and Strategies of Capital Markets Regulation in Europe, in: Veil, European Capital Markets Law, 39, 42.  Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 609.  Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 609. https://doi.org/10.1515/9783110661873-006

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tal regulation is relatively slow and may sometimes take too long to keep pace with structural changes and technical developments. The legislative process often fails where immediate regulatory intervention or adaption is necessary. Therefore, self-regulation plays an important role in the regulation of the securities markets. However, the lack of one single regulatory authority also has its disadvantages. It may often lead to overlapping responsibilities, causing avoidable costs and resulting in uncertainty among market participants about the rules they are subject to and about the competent regulator they should ask for guidance.⁶ Another issue arises concerning the costs associated with regulatory intervention, such as expenses for compliance, personnel and equipment. The higher these costs are, the more likely they will be passed on to the individual investor.⁷ This in turn will harm investor confidence and eventually adversely affect market efficiency.⁸ Thus, it is important to provide a cost-benefit analysis when determining whether regulatory intervention is appropriate and which regulatory type and instrument is suited best. In the end, the remaining questions are whether the advantages of a multitude of regulators outweighs the disadvantages, and, in regard to the topic of this study, whether self-regulation prevails over governmental regulation in regard to dark trading.⁹ The regulation of dark trading comprises two basic elements: the regulation of trading venues and the regulation of trading practices. Trading venues are one of the fundamentals of the securities markets and a critical component of its structure: “To different degrees, depending on the nature of the venue and of the instruments traded, trading venues pool liquidity in the instruments traded, facilitate trading and risk management, provide monitoring services, and, overall, allocate resources and mobilize savings.”¹⁰ Given that trading is conducted on trading venues, they are to be considered as one of the pillars of the market. Trading venues function as the pillar of the market, given that if they fail the whole market will be shaken and even small malfunctions could have a signifi-

 Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 609.  Thieme, Wertpapierdienstleistungen im Binnenmarkt (Investment Services in the Internal Market), 106; cf. Mutschler, Internalisierung der Auftragsausfuehrung im Wertpapierhandel (Internalization of Order Execution in Securities Trading), 118.  Thieme, Wertpapierdienstleistungen im Binnenmarkt (Investment Services in the Internal Market), 106.  Cf. Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 598.  Moloney, EU Securities and Financial Markets Regulation, 426.

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cant impact on the market.¹¹ Therefore, trading venue regulation is a major and ambitious task for legislators. Strongly intertwined with the regulation of trading venues is the regulation of trading practices. Since these practices are heavily influenced by technical developments, as can be seen, for instance, with HFT strategies, regulation often needs to quickly adjust to new practices and mainly relies on technical expertise.¹² Thus, regulation by industry and market participants plays an important role in this area, and self-regulatory approaches may provide better results than governmental regulation. In times of a high competition among trading venues, operators of these trading venues have more incentives to supervise their operations and customers and ensure that they comply with the rules since their customers will move on to a competitor if they feel insecure.¹³ Hence, self-regulation is likely to be successful. However, the government will have to step in where conflicts of interest may prevent the success of self-regulation, which may be the case, for instance, if the operator trades for his own account and may benefit from price manipulations.¹⁴ Notably, regulation of trading venues and trading practices was not on the top of international reform agendas until the financial crisis of 2007– 2009 hit the markets and unveiled a lack of supervision and transparency as well as the emergence of regulatory arbitrage regarding the regulation of different trading venues with similar functionality, in particular between venues in the lit sector and the OTC sector, threatening the core objectives of securities regulation.¹⁵ Across all jurisdictions dark trading came under scrutiny and regulators amended their regimes and adopted new rules to overcome those shortcomings. This chapter outlines the key cornerstones of the various regulatory frameworks governing dark trading with a focus on those regulations addressing the

 See Moloney, EU Securities and Financial Markets Regulation, 429 – 430 summarizing possible negative effects due to, for instance, the lack of transparency, supervision, adequate admission standards and fair trading standards.  Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 610.  Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 610.  Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 610; Thelen, Dark Pools – Schattenbörsen im Lichte US-amerikanischer, europäischer und deutscher Kapitalmarktregulierung (Dark Pools – Dark Trading Platforms in the Light of US-American, European and German Capital Market Regulation), 122 et seq.  Moloney, EU Securities and Financial Markets Regulation, 433. These concerns are also reflected in the commitment constituted in the G20 Committee’s statement in 2009. G20, Leaders’ Statement: The Pittsburgh Summit (Sept. 24– 25, 2009), http://ec.europa.eu/archives/commis sion_2010 – 2014/president/pdf/statement_20090826_en_2.pdf (last visited Sept. 25, 2018).

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issues determined in Chapter 2, i. e. (1) transparency of dark venues, (2) market fragmentation, (3) informational asymmetries and fair access, and (4) predatory trading practices and HFT. The main purpose of this chapter is to evaluate whether and how regulators address the issues regarding dark trading and whether they are able to efficiently reduce the negative effects with a minimum impact on the benefits of dark trading. The chapter is structured as follows. The first part (A.) provides an overview of the different regulatory approaches of various jurisdictions, followed by a detailed assessment of the significant regulations of the two major regulatory regimes, the US (B.) and the EU (C.). The fourth part (D.) draws the final conclusion.

A. Overview of Different Regulatory Approaches For a long time, dark trading gained little regulatory attention. However, due to the technological developments and the breaking up of the monopoly of the traditional securities exchanges, alternative trading venues began to populate the securities markets. Moreover, the increasing globalization enhanced cross-border operation of trading venues raising, in particular, jurisdictional issues.¹⁶ As soon as the amount of trades executed away from the national exchanges was increasing and issues arose, regulators became aware of the structural changes the securities markets had undergone and recognized that intervention was necessary to maintain and regain the structural balance.¹⁷ To respond to these structural changes, jurisdictions worldwide have undertaken to modify their regulatory regimes to incorporate the regulation of alternative trading systems and the OTC sector and to address the jurisdictional issues.¹⁸ Furthermore, regulators joined forces to draft common principles and goals to prevent the markets from further crises and to work together on their achievement.¹⁹ According to the IOSCO, there are three general objectives on which securities regulation is based: (1) investor protection; (2) fair, efficient and transparent markets; and (3) reduction of systemic risk.²⁰

 Cf. Collins, 33 Law & Pol’y Int’l Bus. (2002), 481– 506, 483.  Cf. Gadinis, 3 Va. L. & Bus. Rev. (2008), 311– 356, 333.  Collins, 33 Law & Pol’y Int’l Bus. (2002), 481– 506, 483.  Cf. IOSCO, Objectives and Principles of Securities Regulation (Feb. 2008), 3; G20, Leaders’ Statement: The Pittsburgh Summit (Sept. 24– 25, 2009), http://ec.europa.eu/archives/commis sion_2010 – 2014/president/pdf/statement_20090826_en_2.pdf (last visited Sept. 25, 2018).  IOSCO, Objectives and Principles of Securities Regulation (Feb. 2008), 5.

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I. Core Elements of Dark Trading Regulation Concerning dark trading all regulators considered the following as the core elements to pursue those objectives: (1) regulatory authorization and general supervision of trading venues, (2) fair and equitable rules regarding the operation of trading venues, (3) transparency, (4) fair access to information and trading venues, (5) reporting of trading data, (6) prohibition of manipulation and other unfair trading practices.²¹ Although they agreed on the same goals, regulators chose different approaches to achieve them resulting in a variety of rules across the jurisdictions. In general, the level of regulation depends on the market structure²² and the type of financial instrument.²³ Consequently, in some circumstances, different levels of regulation and even exemptions for certain trading venues may be appropriate.²⁴ Overall, most jurisdictions do not generally prohibit dark trading but allow for the operation of dark pools and the execution of dark orders on lit venues.²⁵ Regulations are generally aimed at ensuring that the dark sector does not harm the securities markets and market participants and inhibit the achievement of the objectives of securities regulation. Differences exist in particular in regard to the classification of trading venues and how they are integrated in the market structure, and further in regard to the level of transparency and data reporting requirements as well as fair access requirements. A common driver in venue regulation is transparency, due to its positive impact on price discovery and the depth of liquidity.²⁶ Differences, however, usually exist between the regulation of pre-trade transparency and the regulation of post-trade transparency. The current general approach is to enhance the pretrade transparency regime as necessary to ensure that market participants have access to the trading data that is crucial to make an informed trading decision and to improve price discovery. At the same time, the regime attempts provide exemptions to protect the trading interests of institutional investors and to acknowledge the operational distinctions between the various types of trading

 Cf. IOSCO, Objectives and Principles of Securities Regulation (Feb. 2008), 41.  For instance, some markets have a high degree of OTC trading, such as the UK, whereas others have higher degree of lit trading, such as France. Moreover, markets may differ in regard to the level of competition depending on whether they have regulations in place requiring trading to take place on traditional exchanges or whether they require all venues to provide access to all brokers without restrictions, such as Canada.  Regulations usually differ between equity and non-equity instruments.  Cf. IOSCO, Objectives and Principles of Securities Regulation (Feb. 2008), 42.  IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 15.  Cf. Moloney, EU Securities and Financial Markets Regulation, 430.

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venues.²⁷ In regard to post-trade transparency, the current general approach is to make post-trade information immediately publicly available. Some jurisdictions provide exemptions to allow for a deferred publication of, for instance, large transactions.²⁸ Differences exist in regard to the nature of the information that is disclosed to the public as well as the general process of consolidation and dissemination of trading data.²⁹

II. The Regulatory Environment of the Major Jurisdictions Since dark trading started evolving in the US market first, regulations specifically designed to address dark trading have their origins in the US.³⁰ The US approach was to legally impose and facilitate competition while providing a single market that integrates the vast variety of different trading venues. In the US, dark trading can take place on exchanges or in the form of dark pools, operating either as an alternative trading system (ATS) or a dealer trading system, which must be registered as a broker-dealer.³¹ As such they are subject to specific regulations, including transparency, reporting and fair access requirements. In regard to transparency requirements, trading venues must display their bids and offers. Exemptions apply to ATSs operating below a certain threshold of trading volume and to large size customer orders. Post-trade data must be reported within 30 seconds of execution and then be published. Dark pools, however, are not required to disclose the identities of the counterparties and the execution venue.³² In respect of fair access requirements, operators of ATSs operating below a threshold of five percent of the aggregate trading volume in a specific financial instrument have a high degree of discretion to restrict the access to their venues.³³ The EU regulator followed the US approach soon after by adopting a regulatory regime to cover different categories of trading venues and address issues raised by dark trading. By contrast to the US market, the EU market is far more fragmented as it does not constitute a single market. To facilitate competi-

    US   

Cf. IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 15. IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 16. Cf. IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 17. Cf. Collins, 33 Law & Pol’y Int’l Bus. (2002), 481– 506, 486. See for a detailed analysis of the regime below in section B. Cf. IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 13. IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 17. Cf. 17 C.F.R. § 242.301(b)(5); Klock, 51 Fla. L. Rev. (1999), 753 – 797, 769 – 770.

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tion, while at the same time ensuring that trading takes place under regulatory oversight, the EU provided for several categories to cover different types of trading that are subject to similar requirements. Further, trading venues are required to provide full pre-trade transparency unless they can apply for a pre-trade transparency waiver, available for example for reference price systems and large orders. In contrast to the US, the requirements apply irrespective of any trading volume thresholds. The OTC sector is not subject to these regulations; however, the EU regulator currently took steps to cover more OTC transactions by the regulated venue categories and to move trading from the dark sector back to the lit sector. Real-time post-trade transparency requirements, including the publication of executed trades, apply to all trading venues with some exemptions for a deferred publication that is available for transactions above a certain size and internalization.³⁴ Among the most aggressive countries in confronting and regulating dark trading are Canada and Australia.³⁵ Although the amount of dark trading in those countries is not and never was that significant and their securities markets play a less important role compared to the markets of the US and the EU, they both implemented similar restrictions on dark trading and in particular one rule that is worth analyzing in detail. The Canadian regulator largely adopted the US approach, but rather than classifying ATSs as exchanges or broker-dealers, the Canadian regulations cover both exchanges and ATSs under one category of ‘marketplace’ and make distinctions within the category.³⁶ Dark pools are regulated as ATSs and are required to register as investment dealers and become members in a self-regulatory organization.³⁷ Other forms of dark trading can also take place on the exchanges and may be subject to their specific requirements. By contrast to the US, Canada places limitations on the types of financial instruments that can be traded on dark pools.³⁸ Transparency requirements equally apply to all market places. All orders are required to be provided and disseminated to the information processor, unless that order is shown to only employees of the trading venue or

 IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 17.  Cf. Popper, Rise of Dark-Pool Trading Concerns Regulators, The New York Times (Mar. 31, 2013), https://www.nytimes.com/2013/04/01/business/as-market-heats-up-trading-slips-into-shad ows.html (last visited Sept. 25, 2018).  Collins, 33 Law & Pol’y Int’l Bus. (2002), 481– 506, 487, 497.  Cf. IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 13; Ontario Securities Commission, National Instrument 21– 101, Sec. 1.1 and Sec. 6.1.  Collins, 33 Law & Pol’y Int’l Bus. (2002), 481– 506, 497– 498.

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someone assisting with the operating of the trading venue.³⁹ The Canadian regime further differs from the US regime in their fair access regulations. While dark venues in the US can exercise discretion and may restrict their access, in Canada, dark venues are required to provide access to all brokers.⁴⁰ The most significant difference between the two regulatory systems, however, is in the regulation of trade execution and pricing. In October 2012, the Investment Industry Regulatory Organization of Canada (IIROC) and the Canadian Securities Administrators (CSA) enacted regulations specifically addressing issues raised by dark trading which, within months, reduced the amount of dark trading by roughly one third.⁴¹ The most significant regulation was the introduction of the so-called “trade-at rule” which required quotes for smaller-sized orders on an off-exchange venue to represent a meaningful price improvement over the quotes simultaneously displayed on exchanges in order to be executed.⁴² An exemption is provided for large block trades, i. e. dark orders that are larger than 50 standard trading units (5,000 shares) or have a value of more than CAD 100,000.⁴³ Those orders can be executed at the NBBO without any price improvement.⁴⁴ Moreover, the new regulations also require visible orders to receive priority over dark orders so that any order entered on a trading venue must trade with visible orders at the same price on that venue.⁴⁵ In May 2013, the Australian Securities and Investments Commission (ASIC) followed the Canadian approach and adopted similar regulations. Aimed at maintaining dark trading opportunities for large orders of institutional investors while enhancing pre-trade transparency, the new rules also require the prioritizing of lit orders over dark orders and a meaningful price improvement.⁴⁶ The  IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 16.  Cf. Foley/Putniņš J. Fin. Econ. (2016), 1, 6.  Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 581, 583; Foley/Putniņš J. Fin. Econ. (2016), 1, 2, 6 – 7; Buckley, 36 Oxford J. Legal Studies (2016), 242, 268.  The ‘meaningful price improvement’esearchers found that requires a minimum of one full tick relative to the prevailing NBBO. See IIROC, Notice 12– 0130 (Provisions Respecting Dark Liquidity) (Apr. 13, 2012), 7; cf. Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 7; Shorter/Miller, Dark Pools in Equity Trading: Policy Concerns and Recent Developments (Sept. 26, 2014), 15; Foley/Putniņš J. Fin. Econ. (2016), 1, 6 – 7.  See IIROC, Notice 12– 0130 (Provisions Respecting Dark Liquidity) (Apr. 13, 2012), 11; Foley/ Putniņš J. Fin. Econ. (2016), 1, 6 – 7.  See IIROC, Notice 12– 0130 (Provisions Respecting Dark Liquidity) (Apr. 13, 2012), 12; Foley/ Putniņš J. Fin. Econ. (2016), 1, 6 – 7.  Buckley, 36 Oxford J. Legal Studies (2016), 242, 268.  Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 583; New Rule A.4 and new Rule A.6 of ASIC Market Integrity Rules (Competition in Exchange Markets) Amendment 2013 (No 2) implemented in the Corporations Act 2001.

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Australian regime classifies trading venues as licensed financial markets, crossing systems or other alternative venues.⁴⁷ The transparency regulations are similar to the US and require comprehensive publication of pre-trade and post-trade information. Exemptions from pre-trade transparency requirements apply to large orders and block trades and trades with price improvement according to the ‘trade-at rule’.⁴⁸ Pre-trade information is published to the market either immediately through data vendors or with a delay of 20 minutes via a website; exemptions in the form of deferred reporting or publication may apply to large orders.⁴⁹ The fair access regulations in Australia are similar to those in the US. In contrast to the rules in Canada, broker-dealer operated dark pools in Australia are allowed to restrict their access.⁵⁰ The effects of the regulation were largely the same in both countries. Overall, up to that time they had the greatest impact of any adopted rules addressing dark trading.⁵¹ Researchers found that the ‘trade-at rule’ and the minimum price improvement requirement caused a significant and immediate decline in the volume of dark trading.⁵² However, they also found that at the same time market-wide liquidity decreased, spreads widened resulting in higher transactions accost, and informational efficiency lowered, which indicates that the new regulations also inhibited the benefits of dark trading and thus, had an adverse impact on market quality.⁵³ Hence, these regulations may not properly balance the harms and benefits of dark trading but rather overstep the regulatory goals. Despite their different approaches, regulators worldwide agree that the dark sector still lacks regulatory oversight and that they need to work on closing the gaps to prevent systemic risks and negative effects on the market. The US and the

 Cf. ASIC, Guidance on ASIC market integrity rules for competition in exchange markets (May 2015), http://download.asic.gov.au/media/3225864/rg223-published-4-may-2015.pdf (last visited Sept. 25, 2018), RG 223.286 et seqq.  ASIC, Guidance on ASIC market integrity rules for competition in exchange markets (May 2015), http://download.asic.gov.au/media/3225864/rg223-published-4-may-2015.pdf (last visited Sept. 25, 2018), RG 223.164 et seqq.; O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 118.  IOSCO Technical Committee, Issues Raised by Dark Liquidity (Oct. 2010), 16; see also ASIC, Guidance on ASIC market integrity rules for competition in exchange markets (May 2015), http://download.asic.gov.au/media/3225864/rg223-published-4-may-2015.pdf (last visited Sept. 25, 2018), RG 223.226 et seqq., RG 223.269 et seqq., RG 223.233 et seqq.  Foley/Putniņš J. Fin. Econ. (2016), 1, 21.  Buckley, 36 Oxford J. Legal Studies (2016), 242, 268 – 269.  Foley/Putniņš J. Fin. Econ. (2016), 1, 7.  Foley/Putniņš J. Fin. Econ. (2016), 1, 7, 9, 14, 16, 22; O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 119.

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EU are currently the most important markets and leading jurisdictions in regard to dark trading. While the US legislation was a pioneer for the regulation of the dark sector and therefore, was leading the way for other jurisdictions to follow, the EU regulators took action much later, but chose a different approach. A thorough assessment of these two regimes could provide valuable findings and conclusions on how regulators may successfully address the issues raised by dark trading and whether and what kind of regulatory intervention may still be necessary.

B. Regulation of Dark Trading in the US Securities transactions in the US are governed primarily by federal securities law.⁵⁴ The fundamentals of the regulation of secondary market transactions, market professionals, and institutions that facilitate such transactions are codified in the Securities Exchange Act of 1934 (Exchange Act, SEA).⁵⁵ The main task of monitoring the market, enforcing the securities laws, and developing new regulations is largely left with an independent administrative agency: The Securities and Exchange Commission (SEC), established by the Exchange Act and charged with administering the federal securities laws.⁵⁶ The SEC has the power to adopt regulations to interpret and implement the securities laws and to enforce the statutes and regulations.⁵⁷ However, the SEC is not the only authority for the oversight and regulation of the US securities market.⁵⁸ There are other self-regulatory organizations who operate as quasi-private regulatory entities, of which the most important is the Financial Industry Regulatory Authority (FINRA) established in 1939.⁵⁹ FINRA is a private, non-profit, membership-based organization that regulates broker-dealers and may adopt rules, generally to protect investors and the public interest.⁶⁰

 Choi/Pritchard, Securities Regulation, 34.  Choi/Pritchard, Securities Regulation, 34; cf. Coffee/Sale/Henderson, Securities Regulation, 589.  Choi/Pritchard, Securities Regulation, 41; Coffee/Sale/Henderson, Securities Regulation, 589; see also 15 U.S.C. § 78d.  Choi/Pritchard, Securities Regulation, 2.  Coffee/Sale/Henderson, Securities Regulation, 57.  Choi/Pritchard, Securities Regulation, 43; Coffee/Sale/Henderson, Securities Regulation, 57, 72– 75 (providing an overview of how SROs are embedded in the regulatory structure).  Choi/Pritchard, Securities Regulation, 43.

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Since the Securities Acts Amendments of 1975,⁶¹ the primary and overarching goal of the US securities regulation was and still is the establishment of a National Market System composed of multiple competing venues linked through technology.⁶² The SEC was instructed and empowered to pursue five objectives in maintaining fair and orderly markets: (1) economically efficient executions, (2) fair competition, (3) the availability of market information, (4) best execution, and (5) direct interaction among investor orders.⁶³ Over the years, trying to facilitate an appropriately balanced market structure that promotes competition among markets, while minimizing the potentially adverse effects of fragmentation has been a challenging task for the SEC.⁶⁴ One major goal that continued to be the driving force of many regulatory steps was the integration of alternative trading systems that fragmented the market and threatened to create a two-tiered market.⁶⁵ There have been several key regulations addressing alternative trading systems and market fragmentation. A general overview is provided in Chapter 1 (B.I.2.a.). The following part focuses on the main regulatory interventions that shaped the current regime and the latest proposals of the SEC and FINRA governing dark trading.

I. The SEC’s Regulation of Dark Trading In regard to regulating trading venues, the SEC chose an institutional approach, according to which the applicable rules are determined by the classification of the respective trading venue.⁶⁶ There are two categories: national securities ex-

 See for more details in Ch. 1 (B.I.2.a.). See further in Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 12 et seqq.  SEC, Concept Release on Equity Market Structure, Proposed Rule, Release No. 61358 (Jan. 14, 2010), 75 Fed. Reg. (Jan. 21, 2010), 3594– 3614, 3596. See also Sec. 11 A SEA.  Macey/O’Hara, 28 J. Legal Stud. (1999), 17, 18 note 3, 28; Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 574; see 15 U.S.C. § 78k-1(a)(1)(C), (2).  SEC, Concept Release on Equity Market Structure, Proposed Rule, Release No. 61358 (Jan. 14, 2010), 75 Fed. Reg. (Jan. 21, 2010), 3594– 3614, 3597.  Cf. details in Ch. 1 (B.I.2.a.). See also Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 8 et seqq.  Cf. Kumpan, Die Regulierung außerboerslicher Wertpapierhandelssysteme im deutschen, europaeischen und US-amerikanischen Recht (The Regulation of Over-the-Counter Trading Systems in German, European and US Law), 122; Collins, 33 Law & Pol’y Int’l Bus. (2002), 481– 506, 488. Contrary to the SEC’s approach others had recommended a functional approach under which

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changes⁶⁷ and broker-dealers⁶⁸. The SEC focused less on limiting dark trading but instead on improving data transparency, providing fairer access, and limiting market fragmentation.⁶⁹ After some regulatory implementations⁷⁰ the SEC has enacted two main regulations addressing dark trading: (1) Regulation ATS (1998) and (2) Regulation NMS (2005). As recent developments in the market structure revealed that some issues are still not sufficiently solved, the SEC made a couple of proposals for future regulation and started a pilot project including the so-called ‘trade-at rule’ that is already in place in Canada and Australia.

1. Regulation ATS of 1998 As technological changes caused an explosive growth of alternative trading systems offering trading services in the secondary market outside of public exchanges, the SEC was concerned that they created a separate “private market” outside of any regulation and oversight⁷¹ – an absolute nightmare for the regulatory supervisor of the US securities market. Particularly, the SEC was concerned that alternative trading venues offered superior prices and granted access only to certain institutional investors but excluded the investing public.⁷² The first far-reaching step in regulating dark trading, in particular alternative trading systems, was the enactment of the Regulation of Exchanges and Alternative Trading Systems (Regulation ATS) by the SEC in 1998. After a vigorous debate about alternative proposals made in the SEC’s first Concept Release⁷³, it finally adopted the new framework comprised of a new and wider interpretation

ATSs of any type that act only as agents for customers were to be regulated separately according to their economic function. See Macey/O’Hara, 28 J. Legal Stud. (1999), 17, 49, 53 – 54.  See Sec. 6(a) SEA, 15 U.S.C. § 78 f (national securities exchanges).  See Sec. 15(a)(1) SEA, 15 U.S.C. § 78o (registration and regulation of brokers and dealers).  Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 585 – 586.  Cf. Ch. 1 (B.I.2.a.). See also Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 8 et seqq.  Cf. SEC, Final Rules, Regulation of Exchanges and Alternative Trading Systems, Release No. 40760 (Dec 8, 1998), Vol. 63 Fed. Reg. (Dec. 22, 1998), 70844– 70951, 70903; Coffee/Sale/Henderson, Securities Regulation, 652.  SEC, Final Rules, Regulation of Exchanges and Alternative Trading Systems, Release No. 40760 (Dec 8, 1998), Vol. 63 Fed. Reg. (Dec. 22, 1998), 70844– 70951, 70903 – 70904; Coffee/Sale/Henderson, Securities Regulation, 652.  SEC, Securities Exchange Act Release No 34– 38672 (May 23, 1997), 62 Fed. Reg. (June 4, 1997), 30485.

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of the term ‘exchange’ and a set of rules regarding alternative trading systems.⁷⁴ Until then, in order to offer trading services in the secondary market, trading venues had to register as exchanges or were generally treated as broker-dealers.⁷⁵ This, however, is considerably more expensive and bears the burden of stringent requirements to comply with.⁷⁶ To understand why the regulatory changes matter, it is important to take a look at the main differences between broker-dealers and national securities exchanges: (1) Exchanges must make membership available to any registered broker-dealer, whereas ATSs are required to provide fair access only if they exceed the five percent trading volume threshold and internalizers offer their services at their discretion, (2) exchanges must engage in self-regulation activities and market surveillance, which imposes additional costs, (3) and their rules must meet a public interests standard and any changes are subject to SEC approval, (4) exchanges must include their quotations in the consolidated quotation system, whereas ATSs are not required to do this unless they exceed the five percent trading volume threshold and internalizers are also not required to publicly display their prices.⁷⁷ The new rules were intended to eliminate market fragmentation while maintaining a fair and competitive environment.⁷⁸ In particular, the SEC sought to ensure that ATSs were integrated in the National Market System (NMS) and became subject to the oversight of FINRA which regulates broker-dealers.⁷⁹ By allowing ATSs to register as broker-dealers instead of exchanges and thus, to bypass the stricter requirements imposed on exchanges the SEC broke the monopoly of exchanges and opened the market to alternative trading venues

 Klock, 51 Fla. L. Rev. (1999), 753 – 797, 764. See for the final rules SEC, Final Rules, Regulation of Exchanges and Alternative Trading Systems, Release No. 40760 (Dec 8, 1998), Vol. 63 Fed. Reg. (Dec. 22, 1998), 70844– 70951.  Cf. Klock, 51 Fla. L. Rev. (1999), 753 – 797, 764; cf. Zyskind, 91 Chicago-Kent L. Rev. (2016), 411, 414; Zaza, 18 Stan. J.L. Bus. & Fin. (2013), 319, 325.  Zyskind, 91 Chicago-Kent L. Rev. (2016), 411, 414; Zaza, 18 Stan. J.L. Bus. & Fin. (2013), 319, 325.  Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 31.  SEC, Final Rules, Regulation of Exchanges and Alternative Trading Systems, Release No. 40760 (Dec 8, 1998), Vol. 63 Fed. Reg. (Dec. 22, 1998), 70844– 70951, 70859; cf. Klock, 51 Fla. L. Rev. (1999), 753 – 797, 754.  SEC, Final Rules, Regulation of Exchanges and Alternative Trading Systems, Release No. 40760 (Dec 8, 1998), Vol. 63 Fed. Reg. (Dec. 22, 1998), 70844– 70951, 70859. FINRA is a self-regulatory organization regulating broker-dealers and bringing enforcement actions against broker-dealers. Choi/Pritchard, Securities Regulation, 43. See for more details on FINRA below (II.).

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encouraging their growth outside the regulatory framework.⁸⁰ Regulation ATS implemented rules regarding, in particular, the following subjects: (1) definition of alternative trading systems, (2) registration, (3) general requirements and SRO membership, (4) transparency, and (5) fair access.

a. Definition of Alternative Trading System The SEC started off by significantly expanding the definition of ‘exchange’. Under the new Rule 3b‐16(a) the requirements were met simply by bringing together the orders for securities of multiple buyers and sellers, using established non-discretionary methods.⁸¹ Taking an “exception-based” approach, the SEC provided further exemptions, thereby excluding from the definition the systems that only route orders to other facilities for execution, that are operated by a single registered market maker to display its own quotes and orders to its customers, and systems that allow persons to enter orders for execution against the bids and offers of a single dealer.⁸² In addition, the SEC provided a definition of ‘alternative trading system’ in Rule 300(a) which refers to the interpretation of an exchange in Rule 3b-16(a) and thus, effectively constitutes a subset of the definition of an exchange.⁸³ Consequently, every ATS is an exchange, but not every exchange is an ATS.⁸⁴

b. Registration Requirements Trading venues which meet the definition of an ATS can therefore either become an official exchange, register as broker-dealers, or remain exempt due to limited transaction volumes.⁸⁵ However, the SEC also included a catch-all provision by which the SEC can require an ATS to register as an exchange instead of an

 Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 577; Zyskind, 91 Chicago-Kent L. Rev. (2016), 411, 414; Zaza, 18 Stan. J.L. Bus. & Fin. (2013), 319, 325.  17 C.F.R. § 240.3b-16(a)(1),(2); cf. Klock, 51 Fla. L. Rev. (1999), 753 – 797, 765.  17 C.F.R. § 240.3b-16(b); Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 576.  17 C.F.R. § 242.300(a); Klock, 51 Fla. L. Rev. (1999), 753 – 797, 765; cf. Collins, 33 Law & Pol’y Int’l Bus. (2002), 481– 506, 486 stating that the SEC chose the easier path by providing a broad category for ‘exchange’ and defining ATSs by subtraction, i. e. by providing exceptions for particular systems.  Klock, 51 Fla. L. Rev. (1999), 753 – 797, 765. See also the exemptions from the definition of an exchange in 17 C.F.R. § 240.3a1– 1(a). Accordingly, the registration of an ATS determines whether the ATS is exempt.  See 17 C.F.R. § 242.301(a) and 17 C.F.R. § 242.3a1– 1(a); Marciello, 49 Suffolk U. L. Rev. (2016), 163, 173.

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ATS when “an exemption [from exchange regulation] would not be necessary or appropriate in the public interest or consistent with the protection of investors.”⁸⁶

c. General Requirements and SRO Membership Once a trading venue is registered as an ATS it has to fulfill certain requirements under Regulation ATS, including reporting, filing notices, applying security standards, and providing for recordkeeping.⁸⁷ An exemption applies to ATSs with less than five percent of trading volume in all securities which are only required to (1) file with the SEC a notice of operation and quarterly reports, (2) maintain records, including an audit trail of transactions, and (3) refrain from using the words ‘exchange’, ‘stock market’, or similar terms in its name.⁸⁸ Most importantly, by requiring ATSs to register either as an exchange or as a broker-dealer, the SEC ensures that ATSs are also subject to regulatory surveillance and oversight.⁸⁹ As broker-dealers, ATSs are obliged to become a member of a self-regulatory organization (SRO).⁹⁰ Notably, any national securities exchange is classified as an SRO. Thus, these SROs operating competing markets may cause potential conflicts of interest.⁹¹ However, the SEC stated that these conflicts could be managed by the SEC’s oversight.⁹²

 17 C.F.R. § 240.3a1– 1(b)(2); cf. SEC, Final Rules, Regulation of Exchanges and Alternative Trading Systems, Release No. 40760 (Dec 8, 1998), Vol. 63 Fed. Reg. (Dec. 22, 1998), 70844– 70951, 70847; Klock, 51 Fla. L. Rev. (1999), 753 – 797, 765 – 766.  The requirements are listed in 17 C.F.R. § 242.301(b) and further specified in 17 C.F.R. § 242.302, § 242.303.  SEC, Final Rules, Regulation of Exchanges and Alternative Trading Systems, Release No. 40760 (Dec 8, 1998), Vol. 63 Fed. Reg. (Dec. 22, 1998), 70844– 70951, 70847.  SEC, Final Rules, Regulation of Exchanges and Alternative Trading Systems, Release No. 40760 (Dec 8, 1998), Vol. 63 Fed. Reg. (Dec. 22, 1998), 70844– 70951, 70863; cf. Klock, 51 Fla. L. Rev. (1999), 753 – 797, 764– 765, 771.  Sec. 15(b)(8) SEA, 15 U.S.C. 78o(b)(8).  Cf. Collins, 33 Law & Pol’y Int’l Bus. (2002), 481– 506, 489; Klock, 51 Fla. L. Rev. (1999), 753 – 797, 771.  SEC, Final Rules, Regulation of Exchanges and Alternative Trading Systems, Release No. 40760 (Dec 8, 1998), Vol. 63 Fed. Reg. (Dec. 22, 1998), 70844– 70951, 70863.

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d. Transparency Requirements Another key element of Regulation ATS is the extension of the scope of the Order Handling Rules to apply to ATSs.⁹³ The primary intent of the SEC was to address the issue that price-improving orders entered into in an alternative trading system were not publicly displayed.⁹⁴ Rule 301(b)(3) requires ATSs that exceed five percent of the average daily trading volume of a single security and that display the orders to more than one system subscriber to submit their best bids and offers to a trade reporting facility or an exchange to be included in the NBBO.⁹⁵ Exemptions from the “quote rule” are provided to venues, such as dark pools, that do not provide information about their orders to any participant regardless of the volume they execute.⁹⁶

e. Fair Access Regulation ATS also provided a ‘fair access rule’. Under this rule, ATSs that exceed a five percent threshold of the average daily trading volume of a single security are required to allow all market participants to trade against publicly displayed quotes.⁹⁷ Further, ATSs exceeding a trading volume threshold of twenty percent are prohibited to unfairly exclude or limit market participants from accessing their services and becoming a member.⁹⁸

f. Critique and Conclusion Although Regulation ATS enhanced competition among trading venues and facilitated the integration of ATSs into the national market system, many market participants criticized the new rules adopted under Regulation ATS and in par-

 17 C.F.R. § 242.301(b)(3). Briefly recall the Order Handling Rules from Ch. 1 (B.I.2.a.): The Order Handling Rules require a market maker or specialist to make publicly available any superior prices that it privately offers through ECNs. However, until the implementation of Regulation ATS, the rules did not apply to ATSs other than ECNs.  SEC, Final Rules, Regulation of Exchanges and Alternative Trading Systems, Release No. 40760 (Dec 8, 1998), Vol. 63 Fed. Reg. (Dec. 22, 1998), 70844– 70951, 70903; Coffee/Sale/Henderson, Securities Regulation, 650 – 651; Klock, 51 Fla. L. Rev. (1999), 753 – 797, 769.  17 C.F.R. § 242.301(b)(3); cf. Klock, 51 Fla. L. Rev. (1999), 753 – 797, 769.  Palmer, Dark and Lit Markets: A User’s Guide, Institutional Investor Journals (2010), www.ii news.com/site/pdfs/liquidityii_flextrade.pdf (last visited Sept. 25, 2018).  17 C.F.R. § 242.301(b)(5); cf. Klock, 51 Fla. L. Rev. (1999), 753 – 797, 770; Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 348.  Klock, 51 Fla. L. Rev. (1999), 753 – 797, 770.

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ticular the institutional approach taken by the SEC.⁹⁹ The differentiation between only two categories, exchanges and broker-dealers, is not precise enough and moreover, inconsistent.¹⁰⁰ For instance, internal crossing systems of large brokerage firms are not covered by the definition of an exchange although they automatically manage and route order flow sometimes using non-discretionary methods.¹⁰¹ Moreover, due to the requirement of broker-dealers becoming a member of an SRO, ATSs face the dilemma of either registering as broker-dealer and thus, becoming subject to oversight by their competitors, or registering as an exchange, involving the adaption of burdensome regulatory requirements.¹⁰² The fair access rule also caused inconsistencies. In particular, it seems unreasonable that very successful ATSs will have to provide free access and allow competitors to become members, whereas ATSs with a market share lower than five percent are exempted from the rule.¹⁰³ Moreover, this could promote unintended market fragmentation if many small systems, possibly with the same owner, can operate without providing access.¹⁰⁴ Further, critique was expressed because the regulation does not sufficiently integrate all orders into the NMS by creating an exclusion for systems that match customers’ orders without displaying them or that execute orders pursuant to an automated quotation system.¹⁰⁵ The SEC concluded that further regulation was necessary in order to better integrate ATSs into the NMS and to further address the negative effects of the increasing market fragmentation.¹⁰⁶

 Cf. Collins, 33 Law & Pol’y Int’l Bus. (2002), 481– 506, 489 stating that forcing ATSs to choose between registration as an exchange or as a broker-dealer has not satisfied either the concerns of regulators interested in sealing “gaps” in the regulatory structure or the worries of traditional competitors seeking to block inroads into their historical market niches.  Klock, 51 Fla. L. Rev. (1999), 753 – 797, 770.  Klock, 51 Fla. L. Rev. (1999), 753 – 797, 766; cf. Kumpan, Die Regulierung außerboerslicher Wertpapierhandelssysteme im deutschen, europaeischen und US-amerikanischen Recht (The Regulation of Over-the-Counter Trading Systems in German, European and US Law), 161– 162.  Collins, 33 Law & Pol’y Int’l Bus. (2002), 481– 506, 489.  Klock, 51 Fla. L. Rev. (1999), 753 – 797, 770.  Klock, 51 Fla. L. Rev. (1999), 753 – 797, 770.  Coffee/Sale/Henderson, Securities Regulation, 653 noting that some ATSs such as those matching orders received overnight at the market’s opening price or matching unpriced orders at the midpoint of the bid and offer spread are not subject to the fair access rules as provided in Rule 301(b)5(iii).  SEC, Final Rules, Regulation NMS, Release No. 51808 (June 9, 2005), Vol. 70 Fed. Reg. (June 29, 2005), 37496 – 37644, 37497.

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2. Regulation NMS of 2005 The greatest challenge for the SEC in designing and preserving the National Market System was “the tension between its desire to foster competition and its fear of market fragmentation.”¹⁰⁷ This issue came to a head as different trading venues began to trade the same securities, based on different operating systems and rules.¹⁰⁸ The treatment of different trades regarding the same securities at different prices, even inferior to the NBBO, remained an unsolved issue. There were no priority rules in place and trading venues were not obliged to route their orders to the trading venue which offered the best price but were allowed to execute trades within their system notwithstanding prior better offers in another venue.¹⁰⁹ This caused uncertainty among market participants and, more importantly, isolation of the individual venues trading NMS stock resulting in increased market fragmentation. In 2005, the SEC addressed these issues by enacting Regulation National Market System (Regulation NMS) which was designed to overhaul the structure of the securities market by increasing the disclosure requirements and decreasing fragmentation.¹¹⁰ With Regulation NMS, the SEC sought to decrease costs for investors by increasing liquidity and market depth,¹¹¹ and to counteract the widespread market fragmentation.¹¹² The main aim behind Regulation NMS was to further establish a national market system as had been the primary goal since 1975. Thereby, the SEC sought to avoid to facilitate the two extremes of (1) isolated markets that trade an NMS stock without regard to trading in other markets and thereby fragment the competition among buyers and sellers in that stock, and (2) a totally centralized system that loses the benefits of vigorous competition and innovation among individual markets.¹¹³ Regulation NMS

 Coffee/Sale/Henderson, Securities Regulation, 624.  Coffee/Sale/Henderson, Securities Regulation, 624.  Kumpan, Die Regulierung außerboerslicher Wertpapierhandelssysteme im deutschen, europaeischen und US-amerikanischen Recht (The Regulation of Over-the-Counter Trading Systems in German, European and US Law), 165; SEC, Securities and Exchange Act Release No 34– 42450 (Feb 23, 2000), 65 Fed. Reg. (Feb 28, 2000), 10577, 10583.  SEC, Final Rules, Regulation NMS, Release No. 51808 (June 9, 2005), Vol. 70 Fed. Reg. (June 29, 2005), 37496 – 37644, 37497; Mercurio, 33 Rev. Banking & Fin. L. (2013 – 2014), 69 – 77, 71.  SEC, Final Rules, Regulation NMS, Release No. 51808 (June 9, 2005), Vol. 70 Fed. Reg. (June 29, 2005), 37496 – 37644, 37501; Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 577.  SEC, Final Rules, Regulation NMS, Release No. 51808 (June 9, 2005), Vol. 70 Fed. Reg. (June 29, 2005), 37496 – 37644, 37499; Marciello, 49 Suffolk U. L. Rev. (2016), 163, 173.  SEC, Final Rules, Regulation NMS, Release No. 51808 (June 9, 2005), Vol. 70 Fed. Reg. (June 29, 2005), 37496 – 37644, 37499; Davies/Dufour/Scott-Quinn, The MiFID: Competition in a New Eu-

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was compromised of four major rules: (1) Order Protection Rule (Rule 611), (2) Access Rule (Rule 610), (3) Sub-Penny Rule (Rule 612), and (4) Amended Market Data Rules (Rules 601 and 603).¹¹⁴

a. Order Protection Rule The most controversial provision of Regulation NMS is the ‘Order Protection Rule’, also called ‘trade-through rule’, constituted in Rule 611, which is aimed at the intermarket protection against trade-throughs.¹¹⁵ A trade-through occurs when one trading venue executes an order at a price inferior to the price of a protected quotation, usually a limit order, displayed by another trading center.¹¹⁶ Protected quotations are bids and offers that are (1) displayed by an automated trading center and are immediately and automatically executable, (2) disseminated in the consolidated market data feeds, and (3) the ‘best bid’ or ‘best offer’ of a national securities exchange or FINRA.¹¹⁷ The ‘Order Protection Rule’ simply requires that the best price be obtained when that price is immediately available through an automated trading system.¹¹⁸ It therefore mandates trading centers to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the execution of trades at prices inferior to protected quota-

ropean Equity Market Regulatory Structure, in: Ferrarini/Wymeersch, Investor Protection in Europe, 163, 174.  SEC, Final Rules, Regulation NMS, Release No. 51808 (June 9, 2005), Vol. 70 Fed. Reg. (June 29, 2005), 37496 – 37644, 37497; cf. Zaza, 18 Stan. J.L. Bus. & Fin. (2013), 319, 326; Hazen, Treatise on the law of securities regulation: Volume 4, 628 – 629.  Cf. Coffee/Sale/Henderson, Securities Regulation, 628; Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 22. In its first proposals the SEC referred to the rule as ‘Trade-Through Rule’. However, the SEC decided that the term ‘Order Protection Rule’ better captures the nature of the adopted Rule 611. See SEC, Final Rules, Regulation NMS, Release No. 51808 (June 9, 2005), Vol. 70 Fed. Reg. (June 29, 2005), 37496 – 37644, 37497 note 2.  17 C.F.R. § 242.611(a)(1); see definition of “trade-throughs” in 17 C.F.R. § 242.600(b)(77); SEC, Final Rules, Regulation NMS, Release No. 51808 (June 9, 2005), Vol. 70 Fed. Reg. (June 29, 2005), 37496 – 37644, 37501; cf. Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 578.  SEC Division of Trading and Markets, Memorandum to SEC Market Structure Advisory Committee – Rule 611 of Regulation NMS (Apr. 30, 2015), https://www.sec.gov/spotlight/emsac/ memo-rule-611-regulation-nms.pdf (last visited Sept. 25, 2018). See also Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 22.  Cf. SEC Division of Trading and Markets, Memorandum to SEC Market Structure Advisory Committee – Rule 611 of Regulation NMS (Apr. 30, 2015), https://www.sec.gov/spotlight/ emsac/memo-rule-611-regulation-nms.pdf (last visited Sept. 25, 2018).

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tions displayed by other trading centers, subject to an applicable exception.¹¹⁹ However, Rule 611 does not require the routing of orders to the trading venue with the best price, rather it only restricts trades at prices worse than the protected quotation.¹²⁰ Hence trading venues are generally free to execute trades at prices that are equal or better than the protected quotation.¹²¹ To be protected, a quotation must be immediately and automatically accessible.¹²² Thus, an order on a floor-based exchange that would require manual execution is not a protected quotation.¹²³ The rule as adopted applies to the best publicly displayed bid and offer of a trading venue.¹²⁴ With the protection against “trade-throughs” the SEC sought to pursue two main goals: (1) to protect investors from execution at inferior prices, and (2) to promote the display of limit orders and thereby, to encourage the provision of liquidity.¹²⁵

b. Access Rule Protecting the best displayed prices against trade-throughs, however, would be meaningless if broker-dealers and trading centers could not access those prices

 17 C.F.R. § 242.611(a)(1); SEC, Final Rules, Regulation NMS, Release No. 51808 (June 9, 2005), Vol. 70 Fed. Reg. (June 29, 2005), 37496 – 37644, 37501– 37502; Zaza, 18 Stan. J.L. Bus. & Fin. (2013), 319, 326.  SEC Division of Trading and Markets, Memorandum to SEC Market Structure Advisory Committee – Rule 611 of Regulation NMS (Apr. 30, 2015), https://www.sec.gov/spotlight/emsac/ memo-rule-611-regulation-nms.pdf (last visited Sept. 25, 2018).  SEC Division of Trading and Markets, Memorandum to SEC Market Structure Advisory Committee – Rule 611 of Regulation NMS (Apr. 30, 2015), https://www.sec.gov/spotlight/emsac/ memo-rule-611-regulation-nms.pdf (last visited Sept. 25, 2018).  Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 22; Hazen, Treatise on the law of securities regulation: Volume 4, 628 – 630.  Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 22; Hazen, Treatise on the law of securities regulation: Volume 4, 628 – 630.  Hazen, Treatise on the law of securities regulation: Volume 4, 629 – 630; cf. Marciello, 49 Suffolk U. L. Rev. (2016), 163, 173.  SEC Division of Trading and Markets, Memorandum to SEC Market Structure Advisory Committee – Rule 611 of Regulation NMS (Apr. 30, 2015), https://www.sec.gov/spotlight/emsac/ memo-rule-611-regulation-nms.pdf (last visited Sept. 25, 2018); Lauer, Statement of Dave Lauer Before the Securities and Exchange Commission Equity Market Structure Advisory Committee (May 13, 2015), https://static1.squarespace.com/static/5576334ce4b0c2435131749b/t/557b35ede4 b0953edbbde84 f/1434138093441/SEC+MSAC+611+Statement.pdf (last visited Sept. 25, 2018); Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 22.

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fairly and efficiently.¹²⁶ Regulation NMS addresses this issue in Rule 610, the socalled ‘Access Rule’ which requires fair and non-discriminatory access to price quotations for all trading venues.¹²⁷ It further places a limit on access fees to harmonize the pricing of quotations across different markets.¹²⁸ Rule 610 therefore allows ATSs which use the displayed public price for their own price quotes – in particular dark pools – to ensure they are not discriminated against by the exchanges.¹²⁹ However, whereas exchanges were required to display their quotations to all market participants and provide trading information, dark pools were not unless they displayed the quotation to more than one subscriber.¹³⁰ Further Rule 610 requires SROs to establish, maintain, and enforce written rules that, among other things, prohibit their members from “engaging in a pattern or practice of displaying quotations that lock or cross the protected quotations” of other trading centers.¹³¹

c. Sub-Penny Rule Regulation NMS also adopted the ‘Sub-Penny Rule’, constituted in Rule 612, which limits the quoted prices to a tenth of a cent for shares over one dollar and to a hundredth of a cent for shares priced less than one dollar.¹³² The Sub-Penny Rule is designed to prevent jockeying for position in the book without meaningful price differences.¹³³ Effectively, Rule 612 prevents institutional investors and dealers from “stepping ahead” of displayed limit orders of retail investors by offering a one tenth of a cent price improvement.¹³⁴ The main purpose be SEC, Final Rules, Regulation NMS, Release No. 51808 (June 9, 2005), Vol. 70 Fed. Reg. (June 29, 2005), 37496 – 37644, 37502; Coffee/Sale/Henderson, Securities Regulation, 629.  17 C.F.R. § 242.610(a), (b); Coffee/Sale/Henderson, Securities Regulation, 629; Hazen, Treatise on the law of securities regulation: Volume 4, 630.  17 C.F.R. § 242.610(c); SEC, Final Rules, Regulation NMS, Release No. 51808 (June 9, 2005), Vol. 70 Fed. Reg. (June 29, 2005), 37496 – 37644, 37502– 37503; Coffee/Sale/Henderson, Securities Regulation, 629; Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 578.  Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 578.  17 C.F.R. § 242.301(b)(3)(B)(ii). See also Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 578; Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 350.  17 C.F.R. § 242.610(d)(3); SEC, Final Rules, Regulation NMS, Release No. 51808 (June 9, 2005), Vol. 70 Fed. Reg. (June 29, 2005), 37496 – 37644, 37503.  17 C.F.R. § 242.612(a), (b); SEC, Final Rules, Regulation NMS, Release No. 51808 (June 9, 2005), Vol. 70 Fed. Reg. (June 29, 2005), 37496 – 37644, 37503; Zaza, 18 Stan. J.L. Bus. & Fin. (2013), 319, 326.  Hazen, Treatise on the law of securities regulation: Volume 4, 630.  SEC, Final Rules, Regulation NMS, Release No. 51808 (June 9, 2005), Vol. 70 Fed. Reg. (June 29, 2005), 37496 – 37644, 37503; Coffee/Sale/Henderson, Securities Regulation, 629.

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hind the ‘Sub-Penny Rule’ is to promote greater price transparency and consistency and to protect displayed limit orders, thereby improving liquidity and depth.¹³⁵

d. Amended Market Data Rules The SEC further amended the Market Data Rules by adopting Rule 601 and Rule 603 with the purpose to strengthen the existing market data system, the “heart of the NMS”, which provides all investors with real-time access to the best quotations and most recent trades.¹³⁶ The main aim of the market data system as invented in 1975 is to collect and consolidate quotations and trades from different trading venues on a continuous basis and then disseminate the market data to the public in a consolidated stream.¹³⁷ With respect to post-trade transparency Rule 601 requires members of SROs, including any registered ATS, to transmit their trades in NMS stock to the SRO, i. e. the exchanges and FINRA, which will then transmit trades to a Network Processor, the Securities Information Processors (SIP).¹³⁸ However, to promote the wide availability of market data, SRO members are also authorized to distribute their own data independently.¹³⁹ The SEC further adopted Rule 603 to ensure that distribution, consolidation, and display of market data is performed in a fair and reasonable manner.¹⁴⁰ Rule 603(a) provides uniform standards for the distribution of quotations and trades. Under Rule 603(a)(2) SROs and their members are prohibited from ‘unreasonably discriminatory’ distribution of market data.¹⁴¹ However, the Rule itself does not define the term ‘unreasonably discriminatory’. According to the SEC’s interpretation, Rule 603(a) prohibits an SRO or broker-dealer from making available distributed data to a private client any sooner than it transmits the data to a Net-

 SEC, Final Rules, Regulation NMS, Release No. 51808 (June 9, 2005), Vol. 70 Fed. Reg. (June 29, 2005), 37496 – 37644, 37503.  SEC, Final Rules, Regulation NMS, Release No. 51808 (June 9, 2005), Vol. 70 Fed. Reg. (June 29, 2005), 37496 – 37644, 37503; see 17 C.F.R. § 242.601, § 242.603.  SEC, Final Rules, Regulation NMS, Release No. 51808 (June 9, 2005), Vol. 70 Fed. Reg. (June 29, 2005), 37496 – 37644, 37503.  17 C.F.R. § 242.601(a).  SEC, Final Rules, Regulation NMS, Release No. 51808 (June 9, 2005), Vol. 70 Fed. Reg. (June 29, 2005), 37496 – 37644, 37503, 37569.  Cf. SEC, Final Rules, Regulation NMS, Release No. 51808 (June 9, 2005), Vol. 70 Fed. Reg. (June 29, 2005), 37496 – 37644, 37569.  17 C.F.R. § 242.603(a)(2); cf. SEC, Final Rules, Regulation NMS, Release No. 51808 (June 9, 2005), Vol. 70 Fed. Reg. (June 29, 2005), 37496 – 37644, 37569.

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work Processor, which uses the information to construct the NBBO.¹⁴² In addition, Rule 603(b) of Regulation NMS requires that the consolidated market data for each NMS stock be disseminated through a single plan processor. For each security, the consolidated feed includes (1) the NBBO with prices, sizes, and market center identifications, (2) the best bids and offers from each SRO that includes prices, sizes, and market center identifications, and (3) a consolidated set of trade reports in the security.¹⁴³ Rule 603 is generally intended to protect investors and enhance transparency by ensuring that investors of all types get fair and timely access to a single source of affordable, accurate, and reliable information on the best quotations and most recent trade prices for any NMS security at any time during the trading day, no matter where such quotations and trades are displayed in the NMS.¹⁴⁴

e. Critique and Conclusion The SEC enacted Regulation NMS in order to increase disclosure requirements and decrease fragmentation, however, it inadvertently encouraged traders to move to dark pools to avoid the disclosure requirements on public trading venues.¹⁴⁵ The most criticized rule by far is the ‘Order Protection Rule’.¹⁴⁶ On the one hand, Rule 611 enhanced competition as trading venues were competing to offer the best price in order to get trades executed on their venue, and facilitated liquidity, transparency and best execution.¹⁴⁷ On the other hand, however, institu-

 SEC, Final Rules, Regulation NMS, Release No. 51808 (June 9, 2005), Vol. 70 Fed. Reg. (June 29, 2005), 37496 – 37644, 37567, 37569; Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 42. See definition of SIP in 15 U.S.C. § 78c(a)(22)(A).  SEC, Final Rules, Regulation NMS, Release No. 51808 (June 9, 2005), Vol. 70 Fed. Reg. (June 29, 2005), 37496 – 37644, 37588.  SEC, Final Rules, Regulation NMS, Release No. 51808 (June 9, 2005), Vol. 70 Fed. Reg. (June 29, 2005), 37496 – 37644, 37503, 37569.  Mercurio, 33 Rev. Banking & Fin. L. (2013 – 2014), 69 – 77, 71.  Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 22. See for a detailed discussion of critiques of Rule 611 SEC Division of Trading and Markets, Memorandum to SEC Market Structure Advisory Committee – Rule 611 of Regulation NMS (Apr. 30, 2015), https://www.sec.gov/spotlight/emsac/memo-rule-611-regulation-nms. pdf (last visited Sept. 25, 2018) and Lauer, Statement of Dave Lauer Before the Securities and Exchange Commission Equity Market Structure Advisory Committee (May 13, 2015), https:// static1.squarespace.com/static/5576334ce4b0c2435131749b/t/557b35ede4b0953edbbde84 f/ 1434138093441/SEC+MSAC+611+Statement.pdf (last visited Sept. 25, 2018).  SEC Division of Trading and Markets, Memorandum to SEC Market Structure Advisory Committee – Rule 611 of Regulation NMS (Apr. 30, 2015), https://www.sec.gov/spotlight/emsac/ memo-rule-611-regulation-nms.pdf (last visited Sept. 25, 2018).

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tional investors trading in public markets were forced to publicly display their orders and thus, ran the risk of moving the market.¹⁴⁸ In addition, the required routing of orders made it easy for high-frequency traders to predict where orders would be sent and, consequently, created more opportunities for “front-running”.¹⁴⁹ Some argue that high-frequency traders could circumvent Regulation NMS even entirely because the regulation failed to specify the speed of the SIP that collects data to calculate the NBBO.¹⁵⁰ According to them, the technology used to perform calculations for the SIP was outdated, so that high-frequency traders created their own, much faster SIP and hence are able to get the information milliseconds faster than ordinary investors.¹⁵¹ Therefore, Rule 611 turned out to be ineffective at reaching its goals of protecting investors from inferior prices and promoting the display of limit orders.¹⁵² In fact, Rule 611 indirectly led to more dark trading by “constraining the nature of competition on lit venues to factors such as speed, fees, and exotic order types, in contrast to factors that are more appealing to investors, such as liquidity and stability”.¹⁵³ Hence, Rule 611 contributed to excessive market fragmentation, thereby increasing market complexity and connectivity costs of market participants.¹⁵⁴

 Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 578.  Marciello, 49 Suffolk U. L. Rev. (2016), 163, 173 – 174; Zaza, 18 Stan. J.L. Bus. & Fin. (2013), 319, 326.  Marciello, 49 Suffolk U. L. Rev. (2016), 163, 174; Lewis, Flash Boys, 97– 98; Patterson, Dark Pools, 49.  Marciello, 49 Suffolk U. L. Rev. (2016), 163, 174; Lewis, Flash Boys, 98 – 100; Patterson, Dark Pools, 50.  Lauer, Statement of Dave Lauer Before the Securities and Exchange Commission Equity Market Structure Advisory Committee (May 13, 2015), https://static1.squarespace.com/static/ 5576334ce4b0c2435131749b/t/557b35ede4b0953edbbde84 f/1434138093441/SEC+MSAC+611+State ment.pdf (last visited Sept. 25, 2018).  SEC Division of Trading and Markets, Memorandum to SEC Market Structure Advisory Committee – Rule 611 of Regulation NMS (Apr. 30, 2015), https://www.sec.gov/spotlight/emsac/ memo-rule-611-regulation-nms.pdf (last visited Sept. 25, 2018). The SEC states that “[t]he substantial increase in trading by dark venues means that displayed limit orders interact with a much smaller percentage of volume today than they did prior to Rule 611. This development may suggest that Rule 611 has not achieved the objective of rewarding the display of limit orders by increasing their likelihood of execution.” See also Lauer, Statement of Dave Lauer Before the Securities and Exchange Commission Equity Market Structure Advisory Committee (May 13, 2015), https://static1.squarespace.com/static/5576334ce4b0c2435131749b/t/557b35ede4b0953edb bde84f/1434138093441/SEC+MSAC+611+Statement.pdf (last visited Sept. 25, 2018).  SEC Division of Trading and Markets, Memorandum to SEC Market Structure Advisory Committee – Rule 611 of Regulation NMS (Apr. 30, 2015), https://www.sec.gov/spotlight/emsac/ memo-rule-611-regulation-nms.pdf (last visited Sept. 25, 2018).

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Further, critiques were expressed in regard to Rule 603(a)(2) and the SEC’s interpretation of ‘unreasonably discriminatory’.¹⁵⁵ The main issue is that, according to the SEC, trading venues are prohibited only from transmitting the data to private clients any sooner than they transmit it to the SIP. This, however, is based on when the trading venue sends a signal, not when traders actually receive it.¹⁵⁶ Trading venues also offer private feeds of the same data they send to the SIP, or co-location services to market participants assuring the minimum possible delay in receipt of the data.¹⁵⁷ Due to technical conditions, traders getting the data directly from the trading venue will receive it with a timely advantage compared to those who get the data from the SIP with a slight delay even though the trading venue sends the data to the SIP and the private client simultaneously.¹⁵⁸ Thus, although the trading venue acts in accordance with Rule 603(a)(2) – as interpreted by the SEC – the simultaneous distribution of data to private clients and the SIP will, in fact, lead to discriminatory results the SEC aimed to prevent by the Rule. Recommendations have been made for an alternative interpretation under which it would be ‘unreasonably discriminatory’ to send a signal that will reach private customers before the SIP core data are publicly available.¹⁵⁹ In general, critics call for reforms, in particular, in regard to dark trading. Recommendations were made to re-examine forces that drive trading off-exchange, including the lack of appropriate disclosure and transparency requirements for dark pool operations and the lack of requirements for off-exchange executions of non-block orders to contribute to meaningful price improvement.¹⁶⁰

 Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 42.  Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 42.  Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 42. See details in Ch. 1 (B.I.1.).  Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 42.  Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 42 note 154 referring to Nanex, Direct vs SIP Data Feed (Apr. 4, 2014), http://www. nanex.net/aqck2/4599.html (last visited Sept. 25, 2018); Nanex, HFT Front Running, All The Time (Sept. 30, 2018), http://www.nanex.net/aqck2/4442.html (last visited Sept. 25, 2018).  Lauer, Statement of Dave Lauer Before the Securities and Exchange Commission Equity Market Structure Advisory Committee (May 13, 2015), https://static1.squarespace.com/static/ 5576334ce4b0c2435131749b/t/557b35ede4b0953edbbde84 f/1434138093441/SEC+MSAC+611+State ment.pdf (last visited Sept. 25, 2018).

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3. Latest Regulatory Proposals by the SEC In the aftermath of Regulation ATS and Regulation NMS, the SEC realized that ATSs were still not fully integrated into the NMS and that, contrary to expectations, a considerable amount of trading took place off-exchange on dark pools operating below the threshold that triggers stricter requirements under Regulation ATS. The institutional approach taken by the SEC caused unforeseen difficulties.¹⁶¹ As simple as the two categories are, the differences between the trading venues are more complex and thus, the classification as either exchange or broker-dealer may not always lead to satisfying results. Consequently, the US securities market relentlessly developed towards a two-tiered market rather than a national market system. Confronted with the concern that the regulatory framework fails at pursuing the goal of facilitating the establishment of a national market system as directed by Section 11 A(a)(2) of the Exchange Act,¹⁶² the SEC re-examined the regulations on several occasions and made further proposals to improve the current market structure and market quality. In the course thereof, the SEC recently made four important proposals¹⁶³: (1) a proposal to integrate dark pools into the NMS by lowering the trading volume threshold from 5 percent to 0.25 percent for ATSs for displaying best-priced orders, (2) a pilot project imposing the so called ‘trade-at rule’ to achieve price improvements, (3) a proposal to create the same level of post-trade transparency for dark pools as for registered exchanges by amending existing rules to require realtime disclosure of the dark pool that executed the trade, and (4) a proposal to enhance order handling information available to investors by amending current disclosure requirements to apply to institutional orders as well.

a. Proposal to Integrate Dark Pools Into the NMS One of the major issues that the SEC had to deal with was the five percent threshold functioning as a trigger for stricter requirements on ATSs, such as the order display rule and the fair access rule. Five percent of daily trading volume is all that matters for ATSs to either operate almost anonymously in the dark, if they remained below the threshold, or to cause for costly and burdensome requirements to apply, if they exceeded the threshold. Hence, it became an issue of business strategy rather than a regulatory measure to decide whether to be a

 See the explanation of the SEC’s approach in the introduction above in section B.I.  15 U.S.C. § 78k-1(2).  Overview in Batista, 14 J. High Tech. L. (2014), 83, 84; Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 352– 53.

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lit ECN or a dark pool, i. e. whether to exceed the threshold or not.¹⁶⁴ Moreover, even large ATSs exceeding the threshold could still avoid triggering the order display rule by not displaying system orders to other subscribers, but instead communicating only Indications of Interests (IOIs).¹⁶⁵ Consequently, ATSs did not generally account for a sufficient portion of trading in individual stocks and successfully avoided triggering the order display and fair access requirements.¹⁶⁶ Soon it was evident that Regulation ATS had failed to integrate ATSs into the NMS. Thus, on November 13, 2009, the SEC released a proposal to amend Regulation ATS to broaden the application of the order display rule and thereby to enhance transparency of dark pools and integrate more ATSs into the NMS.¹⁶⁷ The proposed amendments consist of three regulatory changes: (1) treating IOIs that the SEC deems to be ‘actionable’ as firm ‘bids’ or ‘offers’, (2) lowering the threshold that triggers public order display and fair access requirements for ATSs from 5 percent to 0.25 percent of average daily trading volume, and (3) requiring ATSs trading in NMS securities to identify their transactions to the consolidated trade reporting system.¹⁶⁸ First, the SEC intends to extend the scope of bids and offers to include ‘actionable IOIs’, the messages that dark pools send to selected market participants and other dark pools inducing them to route orders to the sending dark pool.¹⁶⁹ Although these IOIs may not explicitly specify the price and size of available trading interest at the trading venue, they effectively alert the recipient that the dark pool currently has trading interest in a particular security, buy or sell side, size, and price equal or better than the NBBO, and thus intend to attract  Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 21.  Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 21. For explanation of IOIs see Ch. 2 (B.II.2.a. and B.III.1.b.).  SEC, Proposed Rules and Amendments, Regulation of Non-Public Trading Interest, Release No. 60997 (Nov. 13, 2009), Vol. 74 Fed. Reg. (Nov. 23, 2009), 61208, 61214. Accordingly, “[f]ew if any dark pool ATSs exceed the 5 % threshold for any NMS stocks although […] ATSs collectively account for a significant share of trading volume.”; Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 21.  SEC, Proposed Rules and Amendments, Regulation of Non-Public Trading Interest, Release No. 60997 (Nov. 13, 2009), Vol. 74 Fed. Reg. (Nov. 23, 2009), 61208; see also Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 21.  SEC, Proposed Rules and Amendments, Regulation of Non-Public Trading Interest, Release No. 60997 (Nov. 13, 2009), Vol. 74 Fed. Reg. (Nov. 23, 2009), 61208, 61208; Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 344– 345.  SEC, Proposed Rules and Amendments, Regulation of Non-Public Trading Interest, Release No. 60997 (Nov. 13, 2009), Vol. 74 Fed. Reg. (Nov. 23, 2009), 61208, 61209, 61211– 61212. See also Ch. 2 (B.III.1.b.).

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immediately executable order flow similar to displayed quotations.¹⁷⁰ Thus, sending out IOIs leads in fact to the result that the dark pool is “lit” to selected market participants but remains dark to the rest of the public, thereby potentially creating a two-tiered access to information – a situation that ought to be prevented by Rule 301(b)(3).¹⁷¹ The SEC recognizes that the availability of ‘actionable’ IOIs at NBBO matching prices may deprive those who publicly display their interest at the best price from receiving a speedy execution at that price and thus, generally reduce the incentives of market participants to quote publicly.¹⁷² Therefore, the SEC proposed to amend the definition of ‘bid or offer’ in Rule 600(b)(8) to also cover IOIs that are ‘actionable’.¹⁷³ However, it remains unclear what the term ‘actionable’ exactly means.¹⁷⁴ The SEC states that all of the facts and circumstances surrounding the IOI ought to be considered, including “the course of dealing between the IOI sender and the IOI recipient”.¹⁷⁵ This approach, however, is very wide and will likely cover any IOI.¹⁷⁶ Notably, the pro-

 See for a detailed description SEC, Proposed Rules and Amendments, Regulation of NonPublic Trading Interest, Release No. 60997 (Nov. 13, 2009), Vol. 74 Fed. Reg. (Nov. 23, 2009), 61208, 61210 – 61211.  SEC, Proposed Rules and Amendments, Regulation of Non-Public Trading Interest, Release No. 60997 (Nov. 13, 2009), Vol. 74 Fed. Reg. (Nov. 23, 2009), 61208, 61210; cf. Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 345 – 346.  SEC, Proposed Rules and Amendments, Regulation of Non-Public Trading Interest, Release No. 60997 (Nov. 13, 2009), Vol. 74 Fed. Reg. (Nov. 23, 2009), 61208, 61227.  SEC, Proposed Rules and Amendments, Regulation of Non-Public Trading Interest, Release No. 60997 (Nov. 13, 2009), Vol. 74 Fed. Reg. (Nov. 23, 2009), 61208, 61212– 61213. The SEC further proposes to exclude any IOIs “for a quantity of NMS stock having a market value of at least USD 200,000 that are communicated only to those who are reasonably believed to represent current contra-side trading interest of at least USD 200,000”. With this amendment the SEC recognizes that some trading venues, such as block crossing networks, may use actionable IOIs as part of a trading mechanism that offers significant size discovery benefits, particularly valuable for institutional investors that need to trade efficiently in sizes. See also Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 347.  The SEC provides that an IOI would, for example, be considered actionable if it explicitly or implicitly conveys all of the following information about available trading interest at the IOI sender: (1) symbol, (2) side (buy or sell), (3) a price that is equal to or better than the NBBO, and (4) a size that is at least equal to one round lot. SEC, Proposed Rules and Amendments, Regulation of Non-Public Trading Interest, Release No. 60997 (Nov. 13, 2009), Vol. 74 Fed. Reg. (Nov. 23, 2009), 61208, 61212.  SEC, Proposed Rules and Amendments, Regulation of Non-Public Trading Interest, Release No. 60997 (Nov. 13, 2009), Vol. 74 Fed. Reg. (Nov. 23, 2009), 61208, 61212.  Cf. Barrentine/Lofchie, Securities and Exchange Commission proposes regulation of indications of interest and dark pools, Lexology (Nov. 23, 2009), https://www.lexology.com/library/ detail.aspx?g=58df51a1-9707- 48bb-9e8a-6d249b148c37 (last visited Sept. 25, 2018).

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posed amendments would also impact the scope of the definition of ATS in Rule 300(a) and cause more broker-dealers sending actionable IOIs to become subject to the registration requirements under Regulation ATS.¹⁷⁷ The second part of the SEC’s proposal provides an amendment of Rule 301(b)(3)(i)(B) lowering the average daily trading volume threshold from 5 percent to 0.25 percent – a substantial reduction of 95 percent.¹⁷⁸ ATSs exceeding the threshold during at least four of the preceding six calendar months would be subject to the display and access requirements of Rules 301(b)(3)(ii) and 301(b)(3)(iii), respectively, with the consequence that they would have to incorporate their best-priced orders in the NMS.¹⁷⁹ This would affect many dark pools and significantly hamper their operation. Third, the SEC is proposing to amend the joint-industry plans for publicly disseminating consolidated trade data to require real-time disclosure of the identity of dark pools and other ATSs on the reports of their executed trades.¹⁸⁰ Currently, under Rule 601(b) of Regulation NMS, ATSs are required to report their trading information through the SRO they are a member of.¹⁸¹ However, their trades are identified as OTC trades with no identification of the particular broker-dealer or ATS that reported the trade.¹⁸² According to the third proposal, any trading venue, whether dark or lit, would have to provide real-time identification

 Cf. Barrentine/Lofchie, Securities and Exchange Commission proposes regulation of indications of interest and dark pools, Lexology (Nov. 23, 2009), https://www.lexology.com/library/ detail.aspx?g=58df51a1-9707- 48bb-9e8a-6d249b148c37 (last visited Sept. 25, 2018).  SEC, Proposed Rules and Amendments, Regulation of Non-Public Trading Interest, Release No. 60997 (Nov. 13, 2009), Vol. 74 Fed. Reg. (Nov. 23, 2009), 61208, 61213; Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 349.  SEC, Proposed Rules and Amendments, Regulation of Non-Public Trading Interest, Release No. 60997 (Nov. 13, 2009), Vol. 74 Fed. Reg. (Nov. 23, 2009), 61208, 61213.  SEC, Proposed Rules and Amendments, Regulation of Non-Public Trading Interest, Release No. 60997 (Nov. 13, 2009), Vol. 74 Fed. Reg. (Nov. 23, 2009), 61208, 61218, note 85. “The joint-industry plans that provide for the dissemination of last sale information for equity securities are the Consolidated Tape Association Plan (‘‘CTA Plan’’) and the Joint Self-Regulatory Organization Plan Governing the Collection, Consolidation, and Dissemination of Quotation and Transaction Information for Nasdaq-Listed Securities Traded on Exchanges on an Unlisted Trading Privileges Basis (‘‘Nasdaq UTP Plan’’) (collectively ‘‘the Plans’’).  Trades executed by ATSs and other OTC trades are reported to the consolidated trade streams through one of the trade reporting facilities (TRFs) operated by FINRA. See SEC, Proposed Rules and Amendments, Regulation of Non-Public Trading Interest, Release No. 60997 (Nov. 13, 2009), Vol. 74 Fed. Reg. (Nov. 23, 2009), 61208, 61219.  SEC, Proposed Rules and Amendments, Regulation of Non-Public Trading Interest, Release No. 60997 (Nov. 13, 2009), Vol. 74 Fed. Reg. (Nov. 23, 2009), 61208, 61219.

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of all executed trades.¹⁸³ An exemption would apply only to those trades executing a quantity of NMS stock with a market value of at least USD 200,000.¹⁸⁴ Those trades would continue to be reported as OTC trades without an ATS identifier.¹⁸⁵ “The proposed amendments are designed to create a more level playing field with respect to order display and execution access for all market participants that receive and attempt to execute orders, including exchanges, ATSs, and OTC market makers.”¹⁸⁶ However, the approach is highly disputable. Operators of ATSs argued that the existence of dark pools was not a new phenomenon and that its impact on the market and market participants was not harmful.¹⁸⁷ The main criticism is that the proposal hardly addresses the issues of information leakage and front-running.¹⁸⁸

b. Proposal of Trade-at Rule Another attempt to find a solution to the issue of increasing off-exchange trading is the implementation of a so-called ‘trade-at rule’. The rule requires trading venues not publicly displaying the NBBO, i. e. dark pools and internalizers, to either execute the order at a price significantly better than the NBBO, or route the order to a venue that is displaying the NBBO.¹⁸⁹ Thus, the trade-at rule prohibits a trading venue from executing an order at the NBBO unless it was already displaying

 SEC, Proposed Rules and Amendments, Regulation of Non-Public Trading Interest, Release No. 60997 (Nov. 13, 2009), Vol. 74 Fed. Reg. (Nov. 23, 2009), 61208, 61219. See also Palmer, Dark and Lit Markets: A User’s Guide, Institutional Investor Journals (2010), www.iinews.com/site/ pdfs/liquidityii_flextrade.pdf (last visited Sept. 25, 2018).  SEC, Proposed Rules and Amendments, Regulation of Non-Public Trading Interest, Release No. 60997 (Nov. 13, 2009), Vol. 74 Fed. Reg. (Nov. 23, 2009), 61208, 61220.  SEC, Proposed Rules and Amendments, Regulation of Non-Public Trading Interest, Release No. 60997 (Nov. 13, 2009), Vol. 74 Fed. Reg. (Nov. 23, 2009), 61208, 61220.  SEC, Proposed Rules and Amendments, Regulation of Non-Public Trading Interest, Release No. 60997 (Nov. 13, 2009), Vol. 74 Fed. Reg. (Nov. 23, 2009), 61208, 61216.  Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 21.  Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 354.  Weaver, The Trade-At Rule, Internalization, and Market Quality (Apr. 17, 2014), 28; SEC, Order Directing the Exchanges and the Financial Industry Regulatory Authority to Submit Tick Size Pilot Plan, Release No. 72460 (June 24, 2014), 79 Fed. Reg. (June 30, 2014), 36840, 36845 – 36846; Shorter/Miller, Dark Pools in Equity Trading: Policy Concerns and Recent Developments (Sept. 26, 2014), 10.

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that price when the order arrived.¹⁹⁰ Exemptions may apply, for instance, if the order is of block size.¹⁹¹ Beginning on October 3, 2016 the national stock exchanges, NASDAQ, and FINRA implemented a two-year long pilot project called the “Tick Size Pilot Program”, under which one test group of securities is subject to the trade-at rule.¹⁹² By reducing broker discretion over order routing, the SEC aims to inhibit the migration of trading volume away from the lit sector to the dark sector.¹⁹³ Trade-at rules proved to significantly reduce dark pool trades in Canada and Australia which adopted equivalent rules previously in 2012 and 2013.¹⁹⁴ However, the rule has also been criticized. Most notably, it would force dark pools and internalizers to offer a price improvement in order to execute a trade on their venue. This would have a significant impact on their business. Dark pool operators contend that a trade-at rule would increase trading costs and make it more difficult for traders to fill and complete trading orders. Further, large traders are concerned about increasing price impact of their trades as their trades may be routed to lit venues. Moreover, without a concrete definition of a ‘meaningful’ price improvement the rule may incentivize internalizers to “step ahead” of the NBBO by trivial amounts.¹⁹⁵ Therefore, it is not surprising

 Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 36 – 37.  SEC, Order Directing the Exchanges and the Financial Industry Regulatory Authority to Submit Tick Size Pilot Plan, Release No. 72460 (June 24, 2014), 79 Fed. Reg. (June 30, 2014), 36840, 36845 – 36846.  SEC, Order Directing the Exchanges and the Financial Industry Regulatory Authority to Submit Tick Size Pilot Plan, Release No. 72460 (June 24, 2014), 79 Fed. Reg. (June 30, 2014), 36840, 36845; Zyskind, 91 Chicago-Kent L. Rev. (2016), 411, 423 et seqq.; Shorter/Miller, Dark Pools in Equity Trading: Policy Concerns and Recent Developments (Sept. 26, 2014), 10 – 11. In general, the Tick Size Pilot is a data-driven test to evaluate whether or not widening the tick size for securities of smaller capitalization companies would impact trading, liquidity, and market quality of those securities. See for details and further references: SEC, Investor Alert: Tick Size Pilot Program – What Investors Need To Know (Oct. 3, 2016), https://www.sec.gov/oiea/ investor-alerts-bulletins/ia_ticksize.html (last visited Sept. 25, 2018).  Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 37; SEC, Order Directing the Exchanges and the Financial Industry Regulatory Authority to Submit Tick Size Pilot Plan, Release No. 72460 (June 24, 2014), 79 Fed. Reg. (June 30, 2014), 36840, 36846.  See for details above in section A.II. IIROC, Notice 12– 0130 (Provisions Respecting Dark Liquidity) (Apr. 13, 2012), 7; ASIC, Guidance on ASIC market integrity rules for competition in exchange markets (May 2015), http://download.asic.gov.au/media/3225864/rg223-published-4may-2015.pdf (last visited Sept. 25, 2018), RG 223.164 et seqq.; cf. Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 7; Foley/Putniņš J. Fin. Econ. (2016), 1, 6 – 7.  Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 37.

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that the concept of a trade-at rule is popular among lit venues and unpopular among dark venues.¹⁹⁶

c. Proposal to Enhance Transparency and Oversight of ATSs As the amount of trades executed in the dark sector increased steadily and regulators had not found a proper solution to curb this development, the focus turned from dealing with the issue of off-exchange trading itself to dealing with the issues raised by off-exchange trading: the lack of transparency and the lack of oversight of dark pools. The SEC therefore sought to enhance the scope of operational disclosures that dark pools would have to provide to the SEC and the public.¹⁹⁷ On November 18, 2015 the SEC proposed new rules and amendments that would require ATSs trading in NMS stock to provide detailed information about their operations and the activities of their broker-dealer operator and its affiliates by filing new Form ATS-N.¹⁹⁸ In particular, ATSs would have to disclose any potential conflicts of interests of the broker-dealer arising, for instance, from its own dealing activities in the dark pool.¹⁹⁹ The disclosures would also contain information about fees, trading services, the types of orders and market data used on the ATS, as well as the execution and priority procedures including the algorithms used to send and receive orders.²⁰⁰ Form ATS-N disclosures would be made publicly available on the SEC’s website, increasing transparency to the public and enhancing the Commission’s ability to oversee dark pools.²⁰¹ The proposed rules are intended to reduce informational asymmetries  Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 37.  In June 2014, SEC Chair Mary Jo White asked the SEC staff to draft recommendations for regulatory changes. Chair Mary Jo White, Enhancing Our Equity Market Structure, SEC (June 5, 2014), https://www.sec.gov/news/speech/2014-spch060514mjw (last visited Sept. 25, 2018).  SEC, Proposed Rule, Regulation of NMS Stock Alternative Trading Systems, Release No. 76474 (Nov 18, 2015); SEC, Press Release 2015 – 261, SEC Proposes Rules to Enhance Transparency and Oversight of Alternative Trading Systems (Nov. 18, 2015), https://www.sec.gov/ news/pressrelease/2015 -261.html (last visited Sept. 25, 2018).  Commissioner Stein, Statement on Proposed Rules to Increase the Operational Transparency of Alternative Trading Systems (ATS), SEC (Nov. 18, 2015), https://www.sec.gov/news/statement/ proposed-rules-to-increase-the-operational-transparency-of-ats.html (last visited Sept. 25, 2018).  SEC, Proposed Rule, Regulation of NMS Stock Alternative Trading Systems, Release No. 76474 (Nov 18, 2015), 26, 152– 153; SEC, Press Release 2015 – 261, SEC Proposes Rules to Enhance Transparency and Oversight of Alternative Trading Systems (Nov. 18, 2015), https://www. sec.gov/news/pressrelease/2015 -261.html (last visited Sept. 25, 2018).  SEC, Proposed Rule, Regulation of NMS Stock Alternative Trading Systems, Release No. 76474 (Nov 18, 2015), 26, 151; SEC, Press Release 2015 – 261, SEC Proposes Rules to Enhance

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between market participants and the broker-dealer operator and to allow market participants to better evaluate potential conflicts of interest of the broker-dealer operator as well as being better informed when evaluating order handling decisions made by their broker.²⁰² And yet, the benefits of the disclosures for other market participants are uncertain. The variety of different ATSs offering different trading services is enormous and the proposal does not provide for the standardization and comparability of the data and reporting across ATSs.²⁰³ This would likely lead to ambiguity and inconsistent comparisons with the result that the information would be of less or no value to market participants. Further, it is not clear whether disclosure of information constitutes the right way to adequately address conflicts of interest.²⁰⁴ Thus, it may be disputable whether the disclosure to this extent is actually useful and whether it provides enough benefits outweighing the harmful impact on dark pools and on institutional investors profiting from the anonymity. In the interest of investor protection, the SEC should consider to introduce a warning obligation or even a ban on proprietary trading by ATS operators.²⁰⁵

Transparency and Oversight of Alternative Trading Systems (Nov. 18, 2015), https://www.sec.gov/ news/pressrelease/2015 -261.html (last visited Sept. 25, 2018).  SEC, Press Release 2015 – 261, SEC Proposes Rules to Enhance Transparency and Oversight of Alternative Trading Systems (Nov. 18, 2015), https://www.sec.gov/news/pressrelease/2015 -261. html (last visited Sept. 25, 2018).  Cf. Commissioner Stein, Statement on Proposed Rules to Increase the Operational Transparency of Alternative Trading Systems (ATS), SEC (Nov. 18, 2015), https://www.sec.gov/news/ statement/proposed-rules-to-increase-the-operational-transparency-of-ats.html (last visited Sept. 25, 2018). Accordingly, the SEC is asking for comments about how to improve the standardization and comparability.  This concern is mentioned by Commissioner Stein, Statement on Proposed Rules to Increase the Operational Transparency of Alternative Trading Systems (ATS), SEC (Nov. 18, 2015), https:// www.sec.gov/news/statement/proposed-rules-to-increase-the-operational-transparency-of-ats. html (last visited Sept. 25, 2018). See also Thelen, Dark Pools – Schattenbörsen im Lichte USamerikanischer, europäischer und deutscher Kapitalmarktregulierung (Dark Pools – Dark Trading Platforms in the Light of US-American, European and German Capital Market Regulation), 319 et seq. emphasizing that the phenomenon of “information overload” has become one of the classic topics of capital market regulation and also applies in the context of the choice of trading venue.  Thelen, Dark Pools – Schattenbörsen im Lichte US-amerikanischer, europäischer und deutscher Kapitalmarktregulierung (Dark Pools – Dark Trading Platforms in the Light of US-American, European and German Capital Market Regulation), 320.

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d. Proposal to Enhance Order Handling Information On July 13, 2016, the SEC voted unanimously to propose amendments to Rules 600 and 606 of Regulation NMS to enhance order handling information available to investors.²⁰⁶ Under the current order routing disclosure obligations constituted in Rule 606, broker-dealers are required to disclose publicly, on a quarterly basis, certain aggregated order routing information for customer orders in NMS securities.²⁰⁷ The information includes the identity of the venues to which five percent or more of retail orders are sent and certain statistics such as the number of market orders or limit orders sent to each venue.²⁰⁸ Further, broker-dealers are required to disclose separately, to a customer upon request, certain customerspecific order routing information, such as the identity of the venue to which the customer’s orders were routed for execution, for the six months prior to the request.²⁰⁹ The term ‘customer order’ is defined as an order that is not for the account of a broker-dealer for a quantity with a market value of less than USD 200,000 for NMS stocks and less than USD 50,000 for options.²¹⁰ Thus, the requirements only applied to small customer orders but not “institutionalsized” orders (orders in exchange-listed stocks with an original market value of at least USD 200,000), which were traditionally handled by broker-dealers in a manual individual manner.²¹¹ Even though some institutional investors received information upon request, the information was not standardized and

 SEC, Press Release 2016 – 140, SEC Proposes Rules to Enhance Order Handling Information Available to Investors (July 13, 2016), https://www.sec.gov/news/pressrelease/2016 -140.html (last visited Sept. 25, 2018) See proposed rule SEC, Release No. 78309, Proposed Rule, Disclosure of Order Handling Information, Vol. 81 Federal Register (July 13, 2016), 49432. Amendments would also be made to Rules 605 and 607 but those do not reflect substantive changes and hence, will not be discussed hereinafter.  See 17 C.F.R. § 242.606; Burns/Browder, SEC Proposes New Rules to Enhance Order Handling Information Available to Investors (July 28, 2016), http://www.willkie.com/~/media/ Files/Publications/2016/07/SEC_Proposes_New_Rules_to_Enhance_Order_Handling_In formation.pdf (last visited Sept. 25, 2018).  17 C.F.R. § 242.606(a)(1).  17 C.F.R. § 242.606(b)(1); cf. Burns/Browder, SEC Proposes New Rules to Enhance Order Handling Information Available to Investors (July 28, 2016), http://www.willkie.com/~/media/Files/ Publications/2016/07/SEC_Proposes_New_Rules_to_Enhance_Order_Handling_Information.pdf (last visited Sept. 25, 2018).  17 C.F.R. § 242.600(b)(18).  SEC, Press Release 2016 – 140, SEC Proposes Rules to Enhance Order Handling Information Available to Investors (July 13, 2016), https://www.sec.gov/news/pressrelease/2016 -140.html (last visited Sept. 25, 2018).

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therefore difficult to compare across broker-dealers.²¹² This caused informational asymmetries and, moreover, an unfair gap among institutional investors. The SEC sought to address this issue and fill the gap by proposing new rules to provide customers with information to help them better evaluate broker-dealer execution practices, in particular, how to handle conflicts of interest and potential information leakage, and to facilitate the comparison of broker-dealers’ order routing services.²¹³ The new proposals would amend the current requirements to apply to large, “institutional” orders as well, both on a quarterly, aggregated basis and in response to individual, customer requests.²¹⁴ The term ‘institutional order’ would be defined as an order to buy or sell a quantity of an NMS stock having a market value of at least USD 200,000, provided that such order is not for the account of a broker-dealer.²¹⁵ In addition, to distinguish the varying disclosure requirements for different sized orders and for clarification, the term ‘customer order’ would be replaced with the term ‘retail order’.²¹⁶ The SEC pointed out that, despite the costs that would be imposed on broker-dealers, the proposed amendments would offer certain benefits.²¹⁷ In particular, the proposed Rule 606(b)(3) would enhance transparency (about order routing and execution quality) for institutional investors, promote competition for brokerage services in the market and thereby provide incentives for broker-dealers to improve their order routing decisions which in turn could lead to better execution quality overall.²¹⁸

 SEC, Release No. 78309, Proposed Rule, Disclosure of Order Handling Information, Vol. 81 Federal Register (July 13, 2016), 49432, 49437. The SEC was concerned that while certain large institutional investors may be able to demand and obtain order handling information from their broker-dealers, smaller institutional investors, may not have the bargaining power to do so.  SEC, Release No. 78309, Proposed Rule, Disclosure of Order Handling Information, Vol. 81 Federal Register (July 13, 2016), 49432, 49434, 49437.  Proposed Rule 606(c) and amended Rule 606(b)(3). SEC, Release No. 78309, Proposed Rule, Disclosure of Order Handling Information, Vol. 81 Federal Register (July 13, 2016), 49432, 49434– 49435, 49468; SEC, Press Release 2016 – 140, SEC Proposes Rules to Enhance Order Handling Information Available to Investors (July 13, 2016), https://www.sec.gov/news/pressrelease/2016 140.html (last visited Sept. 25, 2018).  Proposed Rule 600(b)(31). See SEC, Release No. 78309, Proposed Rule, Disclosure of Order Handling Information, Vol. 81 Federal Register (July 13, 2016), 49432, 49444, 49483.  Proposed amendment to Rule 600(b)(18) to be renumbered as Rule 600(b)(19). SEC, Release No. 78309, Proposed Rule, Disclosure of Order Handling Information, Vol. 81 Federal Register (July 13, 2016), 49432, 49483.  See SEC, Release No. 78309, Proposed Rule, Disclosure of Order Handling Information, Vol. 81 Federal Register (July 13, 2016), 49432, 49484– 49489.  SEC, Release No. 78309, Proposed Rule, Disclosure of Order Handling Information, Vol. 81 Federal Register (July 13, 2016), 49432, 49484.

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e. Critique and Conclusion It is striking that, at the time of this writing, none of the SEC’s proposals addressing issues regarding the increasing off-exchange trading were actually implemented. One reason could be the general concern expressed by critics that the SEC’s proposals were not sufficient to fulfill the mandate set forth in Section 11 A(a)(2) SEA, i. e. to facilitate the establishment of an NMS to link together the multiple individual markets that trade securities, because “[the proposals] appear to be too draconian, unfocused, or will lead to unintended negative consequences”.²¹⁹ Another major critique is that, although the structural and functional differences among the various trading venues have diminished, the regulatory system continues to treat exchanges, ATSs, and internalizers differently.²²⁰ In particular, it seems unreasonable that the majority of trading venues, whether lit or dark, operate automated matching systems and offer similar trading services, but single venues are subject to different regulatory requirements.²²¹ Others raised the concern that by regulating dark pools too heavily, the SEC may inhibit an important sector of the market and may cause more problems than it solves.²²² Although the proposals may be a step in the right direction to better integrate dark trading venues into the NMS, the SEC will have to reconsider its approach and find a more adequate design for future proposals.²²³

II. FINRA’s Regulation of Dark Trading The second major regulatory force in the US securities market is self-regulatory organizations.²²⁴ Acknowledging the power of self-regulation, i. e. “the ability to do what the government cannot do, given the limits of the Constitution and the fear people have of government action”, the SEC was given power to maintain and even encourage the existing SROs.²²⁵ According to Section 15 A SEA, SROs are responsible for the surveillance and oversight of broker-dealers. They can

 Batista, 14 J. High Tech. L. (2014), 83, 106.  Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 29 – 30.  Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 29 – 30.  Batista, 14 J. High Tech. L. (2014), 83, 106.  Cf. Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 357.  The term ‘self-regulatory organization’ is defined in Sec. 3(a)(26) SEA, 17 C.F.R. § 1.52(a)(2).  Coffee/Sale/Henderson, Securities Regulation, 691.

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set rules supplementing the SEC’s rules and federal laws.²²⁶ In contrast to the governmental regulator, self-regulatory organizations can act more swiftly and subtly as they are not bound by due process standards and the viscous protraction of governmental processes.²²⁷ Thus, they ought to have the initial responsibility for preventing fraud or unfairness.²²⁸ Examples of SROs include national exchanges and national securities associations.²²⁹ The largest SRO in the US securities market is the Financial Industry Regulatory Authority (FINRA), established in 1939 as the former National Association of Securities Dealers.²³⁰ FINRA is authorized to adopt rules governing risk oversight, operational regulation and sales practice of broker-dealers and further, to bring enforcement actions against broker-dealers.²³¹ FINRA established its own rulebook including requirements for broker-dealers to record and report order and execution information and to maintain and promote market integrity and investor protection.²³² For example, Rules 6180 et seqq. and 6280 et seqq. govern the reporting of transactions. Accordingly, members must submit their transaction reports as soon as practicable, but no later than 10 seconds, following trade executing.²³³ FINRA took further steps to increase market transparency and investor protection by enhancing its regulatory surveillance of dark pools.²³⁴ In 2014, FINRA implemented rules adopting new reporting requirements for ATSs.²³⁵ FINRA also began to provide on its website comprehensive data and statistics indicating the activity levels in each ATS, including dark pools, all of which is available to the

 Boskovic/Cerruti/Noel, Comparing European and U.S. Securities Regulations, 4.  Coffee/Sale/Henderson, Securities Regulation, 691.  Coffee/Sale/Henderson, Securities Regulation, 691.  Boskovic/Cerruti/Noel, Comparing European and U.S. Securities Regulations, 4.  Coffee/Sale/Henderson, Securities Regulation, 691; Hazen, Treatise on the law of securities regulation: Volume 4, 716; Rühl-Wolfe, 7 Nw. Interdisc. L. Rev. (2014), 327– 362, 351.  Cf. Sec. 15 A SEA; Choi/Pritchard, Securities Regulation, 43; Coffee/Sale/Henderson, Securities Regulation, 686 – 687.  See FINRA, Rules and Guidance, http://www.finra.org/industry/rules-and-guidance (last visited February 17, 2018).  The reporting time was amended several times, starting at 90 seconds, lowered to 30 seconds and then, in 2013, lowered to 10 seconds. See Rules 6282(a), 6380 A(a), 6380B(a) and 6622(a).  Cf. Sgambati, 49 Colum. J.L. & Soc. Probs. (2015 – 2016), 585 – 610, 590.  FINRA, News Release, FINRA Makes Dark Pool Data Available Free to the Investing Public (June 2, 2014), https://www.finra.org/newsroom/2014/finra-makes-dark-pool-data-availablefree-investing-public (last visited Sept. 25, 2018) See also FINRA, Filing Pursuant to Rule 19b-4 SEA, Proposed Rule Change (Sept. 30, 2013), 1– 47.

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public free of charge.²³⁶ Later, in January 2016, the new Rule 4553 was implemented in Rules 6110 and 6610.²³⁷ Under those rules each ATS is required to report to FINRA weekly volume information and number of trades regarding securities transactions within the ATS.²³⁸ The information regarding Tier 1 NMS stocks will then be published on a two-week delayed basis, while information on all other NMS stocks and OTC equity securities will be released two weeks after the first publication. This uniform data reporting system enables FINRA to obtain more information regarding activity conducted on alternative trading systems and to better survey whether dark pools exceed the five percent threshold and whether they comply with the further requirements in Regulation ATS.²³⁹ Moreover, the public dissemination of ATS trading data will enhance market transparency and provide investors with more information about OTC trading activity.²⁴⁰ However, the reporting provisions were also criticized, in particular, because “two-week-old data comprised of only a subset of off-exchange trades” would not actually enhance transparency and thus, the provisions add only little to investor protection and market integrity.²⁴¹ Further, the reporting requirements only applied to ATSs, not to internalizers, so a significant part of the dark sector was not transparent to the public.²⁴² As of April 2, 2016, FINRA expanded the transparency and reporting requirements for OTC trades to include the trading activity of non-ATS electronic trading systems and internalized trades.²⁴³

 See FINRA, https://ats.finra.org/ (last visited Sept. 25, 2018). Those statistics include the numbers of total shares traded each week by security in each ATS.  See FINRA, Filing Pursuant to Rule 19b-4 SEA, Proposed Rule Change Relating to Alternative Trading System Volume and Trading Information (Jan. 8, 2016).  Rules 6110(b)(1) and Rule 6610(b)(1).  FINRA, Filing Pursuant to Rule 19b-4 SEA, Proposed Rule Change (Sept. 30, 2013), 1– 47, 4, 17; Mercurio, 33 Rev. Banking & Fin. L. (2013 – 2014), 69 – 77, 75 – 76; Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 588 – 589.  FINRA, Filing Pursuant to Rule 19b-4 SEA, Proposed Rule Change (Sept. 30, 2013), 1– 47, 4.  Themis Trading LLC, FINRA’s Dark Pool Proposals Shine A Very Dim Light (Oct. 3, 2013), http://blog.themistrading.com/2013/10/finras-dark-pool-proposals-shine-a-very-dim-light/ (last visited Sept. 25, 2018). Themis Trading is an independent institutional agency brokerage firm specializing in equities.  Themis Trading LLC, FINRA’s Dark Pool Proposals Shine A Very Dim Light (Oct. 3, 2013), http://blog.themistrading.com/2013/10/finras-dark-pool-proposals-shine-a-very-dim-light/ (last visited Sept. 25, 2018).  See FINRA, Regulatory Notice 15 – 48, Equity Trading Initiatives: OTC Equity Trading Volume (Nov. 2015), http://www.finra.org/sites/default/files/Regulatory-Notice-15 - 48.pdf (last visited Sept. 25, 2018).

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III. Enforcement Actions and Case Law Analysis Stricter regulations, however, are only useful and effective if they are enforced and any violations of the provisions are prosecuted. While the federal agencies, the SEC and FINRA, focused their attention on proposals to increase surveillance of dark trading and enhance market transparency, at the state level, the New York State Attorney General (NYAG) recently intensified their prosecution and enforcement efforts by initiating several investigations into large dark pools.²⁴⁴ The overarching goal was to reestablish a level playing field and assure compliance with the securities laws, in order to restore public confidence in the markets.²⁴⁵ Those efforts resulted in heavy fines and penalties on dark pool operators for unfair practices, failure to protect confidential trading information, and executing trades at inferior prices to the market price.²⁴⁶

1. Legal Basis and General Liability Rules In theory, there are two ways to enforce securities laws against dark pools and their operators: (1) The SEC can bring actions under Section 17(a) of the Securities Act of 1933 (Securities Act, SA), or (2) individuals can pursue a private cause of action under Rule 10b-5 (under Section 10(b) SEA) or under common law based on a contract claim. However, this private cause of action requires a loss causation element, which presents a significant hurdle to private litigants because the misconduct does not always lead to an economic loss and, even if it did, it may be impossible to prove that the dark pool’s misconduct caused the loss.²⁴⁷ Thus, mistreated subscribers in dark pools will not likely be successful in suing dark pools for misconduct. The same applies to common law rem-

 Sgambati, 49 Colum. J.L. & Soc. Probs. (2015 – 2016), 585 – 610, 590; Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 589. The investigations by the NYAG are part of his “Insider Trading 2.0” initiative. See Schneiderman, Op-Ed: Cracking Down on Insider Trading 2.0, New York State Attorney General (Oct. 11, 2013), https://ag.ny.gov/press-release/op-ed-cracking-down-insidertrading-20 (last visited Sept. 25, 2018).  Schneiderman, Op-Ed: Cracking Down on Insider Trading 2.0, New York State Attorney General (Oct. 11, 2013), https://ag.ny.gov/press-release/op-ed-cracking-down-insider-trading-20 (last visited Sept. 25, 2018).  Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 589.  Zaza, 18 Stan. J.L. Bus. & Fin. (2013), 319, 344– 345. See Sec. 28(a) SEA (“No person permitted to maintain a suit for damages under the provisions of this title shall recover, through satisfaction of judgment in 1 or more actions, a total amount in excess of the actual damages to that person on account of the act complained of.”). See also 15 U.S.C. § 78bb(a)(1).

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edies.²⁴⁸ Even though the subscribers may have a basis for a contract claim as they usually assent to subscription agreements, in practice, they will have difficulty to present and prove actual losses as damages.²⁴⁹ By contrast, the government may have more success bringing an action under Section 17(a) SA because the statute does not require proof of scienter but rather provides for a negligence standard.²⁵⁰ However, Section 17(a) does not provide a private right of action, so this may significantly limit enforcement against dark pools and their operators.²⁵¹ Another effective, though unique, instrument is available at the state level. In New York, the Martin Act, a state law passed in 1921, empowers the NYAG to investigate, regulate, and bring enforcement actions against alleged securities fraud.²⁵² A special characteristic is that under the Martin Act, the NYAG only has to demonstrate that there has been a misrepresentation or omission of material fact during the sale or promotion of securities, but does not have to prove intent, reliance, or damages in order to bring a successful action before the courts.²⁵³ With respect to its jurisdictional scope, the Martin Act is far-reaching as it permits the prosecution of securities fraud that takes place in New York, that is directed to New York from outside the state, and that emanates from New York.²⁵⁴ Further, the NYAG’s decision to conduct a Martin Act proceeding

 Restatement (Second) of Contracts § 347 (1981). Accordingly, the right to damages requires that the injured party can prove losses: “(a) the loss in the value to him of the other party’s performance caused by its failure or deficiency, (b) any other loss, including incidental or consequential loss, caused by the breach.”  Cf. Zaza, 18 Stan. J.L. Bus. & Fin. (2013), 319, 346.  Section 10(b) and Rule 10b-5 require scienter which is defined as “a mental state embracing intent to deceive, manipulate, or defraud.” It also includes recklessness. See Choi/Pritchard, Securities Regulation, 128; Ernst & Ernst v. Hochfelder, 425 U.S. (1976) 185, 186, 201.  Zaza, 18 Stan. J.L. Bus. & Fin. (2013), 319, 344.  Supreme Court, New York County, New York, People ex rel. Schneiderman v. Barclays Capital Inc. (Feb. 13, 2015) 47 Misc.3d 862, *868; Sgambati, 49 Colum. J.L. & Soc. Probs. (2015 – 2016), 585 – 610, 593; Marciello, 49 Suffolk U. L. Rev. (2016), 163, 175.  The Martin Act, New York General Business Law Art. 23-A, Sec. 352– 353. Cf. Marciello, 49 Suffolk U. L. Rev. (2016), 163, 175; Sgambati, 49 Colum. J.L. & Soc. Probs. (2015 – 2016), 585 – 610, 594– 595; Bernstein, The Importance of Shedding Some Light on Dark Pools, The New York Times (July 22, 2014), https://www.nytimes.com/2014/07/23/upshot/the-importance-ofshedding-some-light-on-dark-pools.html (last visited Sept. 25, 2018).  Sgambati, 49 Colum. J.L. & Soc. Probs. (2015 – 2016), 585 – 610, 595. Cf. New York General Business Law Art. 23-A, Sec. 352, 352-a.

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is not subject to judicial review.²⁵⁵ Thus, in fact, the Martin Act gives the NYAG significant discretion and leverage.²⁵⁶ While state laws that apply only in one state are usually of minor relevance, the Martin Act is a powerful instrument of significant importance, given the particular circumstances that the securities trading activity is centered in New York. The effects are therefore enormous and far-reaching. With regard to liability rules, the different classification and different regulatory treatment of exchanges and broker-dealers are highlighted once more. Consistent with the current structure, distinctive liability rules apply to different kinds of trading venues.²⁵⁷ ATSs and internalizers classified as broker-dealers are subject to the same liability rules as any other private financial institution.²⁵⁸ In contrast, exchanges and their officers acting in their capacity as SROs are treated as federal agencies since they perform regulatory functions that would otherwise be performed by the SEC, and thus, enjoy “absolute immunity” from actions for liability and monetary damages.²⁵⁹ Consequently, an exchange “is immune to suits for fraud, incompetence, or other forms of misconduct when engaged in interpretation, discipline, or enforcement, or other activities necessary or critical to its quasi-governmental regulatory functions”.²⁶⁰ These discrepancies between exchanges and ATSs regarding the liability rules and immunity benefits give rise to concerns about regulatory arbitrage and may call for a review of the current structure and categorization of trading venues.²⁶¹ For the purpose of this

 People v. Bunge Corp., 302 N.Y.S.2d 785, 788 (1969). The only issue subject to judicial scrutiny is whether a sufficient factual showing has been made to warrant issuance of the order. See Gonkjur Assocs. v. Abrams, 443 N.Y.S.2d 69, 74 (App. Div. 1981).  This raises a debate about whether the Martin Act infringes on the jurisdiction and mandate of the SEC and thus, should be interpreted more narrowly, or whether the NYAG should be encouraged to fill a “regulatory vacuum” and enhance cooperation between state and federal agencies. See for details Sgambati, 49 Colum. J.L. & Soc. Probs. (2015 – 2016), 585 – 610, 603 – 610.  Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 31– 32.  Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 31– 32.  See 15 U.S.C. § 1122(a). A “self-regulatory organization ‘when acting in its capacity as a SRO, is entitled to immunity from suit when it engages in conduct consistent with the quasi-governmental powers delegated to it pursuant to the Exchange Act and the regulations and rules promulgated thereunder.’” DL Capital Grp., LLC v. Nasdaq Stock Mkt., Inc., 409 F.3d 93, 97 (2d Cir. 2005), citing D’Alessio v. N.Y. Stock Exch., Inc., 258 F.3d 93, 106 (2d Cir. 2001).  Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 32.  Cf. Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 32.

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study, however, the differences in liability are not of further relevance and thus, will not be evaluated in more detail.

2. The Enforcement Actions From October 2011 until December 2016 the SEC settled eight major cases charging dark pools and other ATSs with violations of federal securities laws.²⁶² The issues involved were primarily the absence of appropriate safeguards and oversight procedures to protect confidential subscriber information, and false statements or lack of transparency about the pools’ inner structure and procedures, including whether high frequency traders had been granted access to the pools and had been engaging in front-running and market manipulation.²⁶³ The following part provides an overview of the series of SEC enforcement actions against dark pools and discusses the misconduct and violations as revealed by the SEC.²⁶⁴ The cases demonstrate how the regulations practically impact the issues, show that some of the concerns are not totally groundless, and that the SEC is capable of prosecuting violations and enforcing the rules.

a. In the Matter of Pipeline Trading The first action in this series was brought by the SEC in 2011 against Pipeline Trading Systems, LLC (Pipeline Trading), the operator of a dark pool held out as a crossing network that anonymously matched customers’ interests in trading large amounts of stock.²⁶⁵ The SEC alleged, among other things, that Pipeline Trading did not disclose to its customers that the majority of the shares traded in its dark pool were bought or sold by a wholly owned subsidiary of Pipeline Trading, and therefore, violated Section 17(a)(2) SA and Rules 301(b)(2) and 301(b)(10)²⁶⁶ of Regulation ATS.²⁶⁷ The subsidiary was created to provide enough liquidity to Pipeline Trading’s customers, however, Pipeline Trading did not dis Overview of the settlements provided in SEC, Press Release 2016 – 264, Deutsche Bank Settles Charges of Misleading Clients About Order Router (Dec. 16, 2016), https://www.sec.gov/ news/pressrelease/2016 -264.html (last visited Sept. 25, 2018).  Cf. Freedman, 35 Rev. Banking & Fin. L. (2015 – 2016), 150, 152.  See also Freedman, 35 Rev. Banking & Fin. L. (2015 – 2016), 150 and Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 336 et seqq.  SEC, In the Matter of Pipeline Trading Systems LLC, Exchange Act Release No. 65,609, 2011 WL 5039038 (Oct. 24, 2011) Release No. 9271, *1, *16.  17 C.F.R. § 242.301(b)(2),(10).  SEC, In the Matter of Pipeline Trading Systems LLC, Exchange Act Release No. 65,609, 2011 WL 5039038 (Oct. 24, 2011) Release No. 9271, *1, *15.

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close to its customers the existence and practice of its subsidiary.²⁶⁸ Rather, Pipeline Trading represented itself to be a “natural” crossing network, meaning that it did not itself generate trading opportunities on the dark pool for the purpose of filling a subscriber’s order.²⁶⁹ Pipeline advertised that the dark pool “matched customers’ orders with those from other clients,” providing “natural” liquidity.²⁷⁰ It further asserted that it had no proprietary trading desk gaming customer orders and that the trading opportunities on the dark pool were “natural”, that the dark pool would not reveal the side or price of a customer order before a trade was completed, and that it would not leak information that enables front running by other traders, such as high-frequency traders.²⁷¹ As a result of this conduct revealed by investigations, the SEC found that due to materially misleading statements and omissions of fact, Pipeline Trading violated Section 17(a)(2) SA which prohibits, “directly or indirectly, in the offer or sale of securities, obtaining money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading”.²⁷² Pipeline Trading also failed to file a notice about material change to its dark pool’s operation pursuant to Rule 301(b)(2). Further, the SEC found a violation of Rule 302(b)(10) which requires an ATS to establish adequate safeguards and procedures to protect subscribers’ confidential trading information, and to adopt and implement adequate oversight procedures to ensure that these safeguards and procedures are followed. Pipeline Trading failed to provide sufficient safeguards and procedures causing the emergence of conflicts of interest.²⁷³ Members of its senior management shared confidential information about Pipeline Trading’s customers, including their identities and the side,

 SEC, In the Matter of Pipeline Trading Systems LLC, Exchange Act Release No. 65,609, 2011 WL 5039038 (Oct. 24, 2011) Release No. 9271, *4– 5.  SEC, In the Matter of Pipeline Trading Systems LLC, Exchange Act Release No. 65,609, 2011 WL 5039038 (Oct. 24, 2011) Release No. 9271, *6 – 7; Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 339.  SEC, In the Matter of Pipeline Trading Systems LLC, Exchange Act Release No. 65,609, 2011 WL 5039038 (Oct. 24, 2011) Release No. 9271, *5, *7; Freedman, 35 Rev. Banking & Fin. L. (2015 – 2016), 150, 153.  SEC, In the Matter of Pipeline Trading Systems LLC, Exchange Act Release No. 65,609, 2011 WL 5039038 (Oct. 24, 2011) Release No. 9271, *1, *6 – 7.  SEC, In the Matter of Pipeline Trading Systems LLC, Exchange Act Release No. 65,609, 2011 WL 5039038 (Oct. 24, 2011) Release No. 9271, *1, *15; Freedman, 35 Rev. Banking & Fin. L. (2015 – 2016), 150, 153– 154.  Cf. Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 340.

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size, and price of their orders in stocks, with traders of the subsidiary.²⁷⁴ Another main issue in this regard was that due to the informational advantage, Pipeline Trading’s subsidiary engaged in front-running other subscribers’ orders, which had not been disclosed, and in other predatory trading practices. For example, Pipeline Trading engaged in “spoofing” or “flashing”²⁷⁵, whereby they placed large numbers of orders only to cancel them immediately afterwards for the purpose of pretending the interest to buy or sell orders.²⁷⁶ Because it was almost impossible for other customers to receive this information, the tactic had the effect of pre-positioning the subsidiary in front of the customer orders.²⁷⁷ In the SEC’s order, Pipeline Trading agreed to admit the violation of Section 17(a)(2) SA and Rules 301(b)(2) and 301(b)(10) of Regulation ATS, to pay USD 1 million, and to “cease and desist” from further violations.²⁷⁸ Additionally, the SEC charged Pipeline Trading’s CEO and chairman with personal liability for causing Pipeline Trading to commit the violations.²⁷⁹

b. In the Matter of eBX In 2012, the SEC filed an action against eBX, LLC (eBX), a registered broker-dealer and operator of the dark pool LeveL.²⁸⁰ The operation of LeveL was contractually outsourced to a third-party technology Service Provider.²⁸¹ The latter also had its own order routing business and some of its customers were also LeveL subscribers.²⁸² LeveL subscribers were required to send their orders through the Service Provider to get into LeveL, and the former instructed all sub-

 SEC, In the Matter of Pipeline Trading Systems LLC, Exchange Act Release No. 65,609, 2011 WL 5039038 (Oct. 24, 2011) Release No. 9271, *14– 15.  See for the explanation of those trading practices Ch. 2 (B.IV.1.b.).  SEC, In the Matter of Pipeline Trading Systems LLC, Exchange Act Release No. 65,609, 2011 WL 5039038 (Oct. 24, 2011) Release No. 9271, *6; Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 340.  Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 339.  SEC, In the Matter of Pipeline Trading Systems LLC, Exchange Act Release No. 65,609, 2011 WL 5039038 (Oct. 24, 2011) Release No. 9271, *16.  SEC, In the Matter of Pipeline Trading Systems LLC, Exchange Act Release No. 65,609, 2011 WL 5039038 (Oct. 24, 2011) Release No. 9271, *15.  SEC, In the Matter of eBX, LLC, Release No. 67,969, File No. 3 – 15058 (Oct. 3, 2012); cf. Zaza, 18 Stan. J.L. Bus. & Fin. (2013), 319, 331 et seqq.  SEC, In the Matter of eBX, LLC, Release No. 67,969, File No. 3 – 15058 (Oct. 3, 2012), para. 2, 11.  SEC, In the Matter of eBX, LLC, Release No. 67,969, File No. 3 – 15058 (Oct. 3, 2012), para. 12, 24.

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scribers to send their orders into LeveL through the router.²⁸³ However, this router could retain a record of any order that it submitted, including information such as the source, quantity, received time and pricing characteristics, and thereby save unexecuted order information which was used for LeveL’s own benefit.²⁸⁴ This informational advantage enabled the Service Provider to front-run on subscribers’ orders. Similar to the Pipeline Trading case, the SEC found that eBX, through LeveL, failed to keep the subscribers’ pre-trade information confidential and failed to implement sufficient safeguards by allowing a “smart order router” to remember subscriber information of unexecuted orders lingering in LeveL. These actions were found to have violated Rules 301(b)(2) and Rule 301(b)(10) of Regulation ATS.²⁸⁵ LeveL further failed to amend its Form ATS pursuant to Rule 301(b)(2) in respect of material changes to its operation when it allowed a third party, outside of the dark pool, to make use of the subscribers’ confidential order information.²⁸⁶ In the end, the action was settled and eBX agreed to pay USD 800,000 in civil penalties.²⁸⁷

c. In the Matter of Liquidnet Two years later, in 2014, the SEC charged Liquidnet, Inc. (Liquidnet), a New Yorkbased brokerage firm that operated a block-trading dark pool, for allowing a third party to access the confidential trading data of its subscribers and for improperly using this data in marketing the dark pool’s services.²⁸⁸ According to the SEC’s order, Liquidnet promised to its dark pool subscribers, mainly institutional investors, that it would keep their trading information confidential and allow them to trade with maximum anonymity and minimum information leakage.²⁸⁹ Over a period of three years (from 2009 to 2012), in an effort to find addi-

 SEC, In the Matter of eBX, LLC, Release No. 67,969, File No. 3 – 15058 (Oct. 3, 2012), para. 19 et seqq, 24.  SEC, In the Matter of eBX, LLC, Release No. 67,969, File No. 3 – 15058 (Oct. 3, 2012), para. 17, 24, 28; see also Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 343 – 344.  SEC, In the Matter of eBX, LLC, Release No. 67,969, File No. 3 – 15058 (Oct. 3, 2012), para. 33 et seqq., 44– 45; Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 342.  SEC, In the Matter of eBX, LLC, Release No. 67,969, File No. 3 – 15058 (Oct. 3, 2012), para. 39 et seqq., 44– 45.  SEC, In the Matter of eBX, LLC, Release No. 67,969, File No. 3 – 15058 (Oct. 3, 2012).  See SEC, Press Release 2014– 114, SEC Charges New York-Based Dark Pool Operator With Failing to Safeguard Confidential Trading Information (June 6, 2014), https://www.sec.gov/ news/press-release/2014-114 (last visited Sept. 25, 2018).  SEC, In the Matter of Liquidnet, Inc., File No. 3 – 15912 (June 6, 2014), para. 16 – 17, 41 et seqq.; SEC, Press Release 2014– 114, SEC Charges New York-Based Dark Pool Operator With Fail-

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tional sources of liquidity for its dark pool, Liquidnet launched an Equity Capital Markets desk, a business unit outside the dark pool, to offer its services to corporate issuers and control persons of corporate issuers, private equity, and venture capital firms looking to execute large transactions.²⁹⁰ As the SEC’s investigation revealed, Liquidnet permitted the Equity Capital Markets desk to access confidential information about its customers’ intentions to buy or sell securities and to use it to attract these outside liquidity providers and advise them about, for instance, when to execute transactions according to the liquidity they were able to see.²⁹¹ Thus, Liquidnet allegedly violated its promises to the subscribers and failed to meet its regulatory obligations to amend its Form ATS pursuant to Rule 301(b)(2).²⁹² The SEC also found that Liquidnet violated Section 17(a)(2) SA for false statements of material fact and material omissions.²⁹³ Further, according to the SEC’s order, Liquidnet failed to establish safeguards and procedures to protect the subscribers’ confidential trading information and to adopt and implement adequate oversight procedures to ensure that the safeguards and procedures are followed as required under Rule 301(b)(10). The SEC’s charges resulted in a settlement and a payment of a USD 2 million penalty by Liquidnet even though Liqudinet did not admit or deny any of the allegations.²⁹⁴

d. In the Matter of UBS In January 2015, UBS Securities LLC (UBS) paid a USD 12 million penalty to settle charges against its subsidiary, the dark pool UBS ATS, for failure to meet its disclosure obligations and for violation of Rule 612 of Regulation NMS, the SubPenny-Rule.²⁹⁵ Allegedly, UBS offered a so-called “PrimaryPegPlus” option, an

ing to Safeguard Confidential Trading Information (June 6, 2014), https://www.sec.gov/news/ press-release/2014-114 (last visited Sept. 25, 2018).  SEC, In the Matter of Liquidnet, Inc., File No. 3 – 15912 (June 6, 2014), para. 2, 9.  SEC, In the Matter of Liquidnet, Inc., File No. 3 – 15912 (June 6, 2014), para. 10 – 12.  SEC, In the Matter of Liquidnet, Inc., File No. 3 – 15912 (June 6, 2014), para. 64; SEC, Press Release 2014– 114, SEC Charges New York-Based Dark Pool Operator With Failing to Safeguard Confidential Trading Information (June 6, 2014), https://www.sec.gov/news/press-release/ 2014-114 (last visited Sept. 25, 2018).  SEC, In the Matter of Liquidnet, Inc., File No. 3 – 15912 (June 6, 2014), para. 64.  See also SEC, Press Release 2014– 114, SEC Charges New York-Based Dark Pool Operator With Failing to Safeguard Confidential Trading Information (June 6, 2014), https://www.sec. gov/news/press-release/2014-114 (last visited Sept. 25, 2018).  SEC, Press Release 2015 – 7, SEC Charges UBS Subsidiary With Disclosure Violations and Other Regulatory Failures in Operating Dark Pool (Jan. 15, 2015), https://www.sec.gov/news/

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order type that permitted trades in increments of less than one cent.²⁹⁶ Orders of users of PrimaryPegPlus, usually high-frequency traders and other market makers, were prioritized over other legal orders that used whole-penny increments. This presumably constituted a violation of the Sub-Penny-Rule, which prohibits market participants from displaying, ranking, or accepting quotations, orders, or indications of interest in any NMS stock priced in an increment smaller than $0.01 if the quotation, order, or indication of interest is priced equal to or greater than $1.00 per share.²⁹⁷ Further, UBS also offered a feature called “natural-only cross restriction” based on an algorithm that was intended to prevent certain orders from executing against the orders of high-frequency traders and market makers.²⁹⁸ The SEC found that UBS failed to inform all of its subscribers about these two products, the “PrimaryPegPlus” option and the “natural-only cross restriction”, and offered both of them only to certain investors, in violation of Section 17(a)(2) SA.²⁹⁹ In addition, the SEC determined that due to its disclosure failures, UBS violated Rule 301(b)(2) of Regulation ATS.³⁰⁰ Finally, the SEC alleged UBS of violating Rule 301(b)(10) for allowing employees that neither operated the dark pool nor had responsibility for its compliance functions to access confidential trading information of UBS ATS subscribers.³⁰¹ However, the SEC did not find that the use of the algorithm for the “natural-only cross restriction” was illegal.³⁰² Notwithstanding that UBS did not admit or deny any of the SEC’s findings, it consented to the entry of the SEC’s cease-and-desist-order and paid a fine.

e. In the Matter of ITG The penalties paid so far were topped in August 2015 with more hefty penalties, when Investment Technology Group Inc. and its affiliate AlterNet Securities (together referred to as ITG), the operator of the dark pool POSIT, admitted to

pressrelease/2015 -7.html (last visited Sept. 25, 2018). See also Freedman, 35 Rev. Banking & Fin. L. (2015 – 2016), 150, 158 – 159.  SEC, In the Matter of UBS Securities LLC, File No. 3 – 16338 (Jan. 15, 2015), para. 3.  SEC, In the Matter of UBS Securities LLC, File No. 3 – 16338 (Jan. 15, 2015), para. 3, 11.  SEC, In the Matter of UBS Securities LLC, File No. 3 – 16338 (Jan. 15, 2015), para. 5, 37– 48.  SEC, In the Matter of UBS Securities LLC, File No. 3 – 16338 (Jan. 15, 2015), para. 3 – 5, 12 and 44– 48.  SEC, In the Matter of UBS Securities LLC, File No. 3 – 16338 (Jan. 15, 2015), para. 6.  SEC, In the Matter of UBS Securities LLC, File No. 3 – 16338 (Jan. 15, 2015), para. 8.  This argument is also made by Thelen, Dark Pools – Schattenbörsen im Lichte US-amerikanischer, europäischer und deutscher Kapitalmarktregulierung (Dark Pools – Dark Trading Platforms in the Light of US-American, European and German Capital Market Regulation), 139 – 140.

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wrongdoing and agreed to pay a USD 18 million penalty.³⁰³ The underlying issue was that ITG operated an undisclosed proprietary trading desk, internally known as “Project Omega”, that accessed live feeds of ITG customers and confidential POSIT subscriber order and execution information and that applied HFT strategies based on this information to trade against POSIT subscribers for Project Omega’s own benefit.³⁰⁴ At the same time, ITG advertised itself and POSIT as an “independent ‘agency-only’ broker that did not have conflicts of interest with its customers and that protected the confidentiality of its customers’ trade information”.³⁰⁵ According to the SEC’s order, ITG violated Section 17(a) (2) and (3) SA by defrauding clients and failing to make required disclosures to subscribers.³⁰⁶ ITG also failed to amend its Form ATS pursuant to Rule 301(b)(2).³⁰⁷ Further, ITG violated Rule 301(b)(10) by providing access to confidential subscriber information to individuals other than employees operating the ATS or responsible for its compliance and by failing to establish and implement adequate oversight procedures.³⁰⁸

f. In the Matter of Credit Suisse On January 31, 2016, Credit Suisse Securities (USA), LLC (Credit Suisse) operator of the dark pool “Crossfinder” agreed to settle charges by paying a USD 30 million penalty to both, the SEC and the NYAG, and USD 24.3 million in disgorgement and prejudgment interest to the SEC for a total penalty of USD 84.3 mil-

 SEC, Press Release 2015 – 164, SEC Charges ITG With Operating Secret Trading Desk and Misusing Dark Pool Subscriber Trading Information (Aug. 12, 2015), https://www.sec.gov/ news/pressrelease/2015 -164.html (last visited Sept. 25, 2018).  SEC, In the Matter of ITG Inc. and AlterNet Securities, Inc., File No. 3 – 16742 (Aug. 12, 2015), para. 4; SEC, Press Release 2015 – 164, SEC Charges ITG With Operating Secret Trading Desk and Misusing Dark Pool Subscriber Trading Information (Aug. 12, 2015), https://www.sec.gov/news/ pressrelease/2015 -164.html (last visited Sept. 25, 2018).  SEC, In the Matter of ITG Inc. and AlterNet Securities, Inc., File No. 3 – 16742 (Aug. 12, 2015), para. 6, 73.  SEC, In the Matter of ITG Inc. and AlterNet Securities, Inc., File No. 3 – 16742 (Aug. 12, 2015), para. 8, 72– 73.  SEC, In the Matter of ITG Inc. and AlterNet Securities, Inc., File No. 3 – 16742 (Aug. 12, 2015), para. 9, 78.  SEC, In the Matter of ITG Inc. and AlterNet Securities, Inc., File No. 3 – 16742 (Aug. 12, 2015), para. 75 – 76; SEC, Press Release 2015 – 164, SEC Charges ITG With Operating Secret Trading Desk and Misusing Dark Pool Subscriber Trading Information (Aug. 12, 2015), https://www.sec.gov/ news/pressrelease/2015 -164.html (last visited Sept. 25, 2018).

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lion.³⁰⁹ According to the SEC’s allegations, Credit Suisse failed to treat subscriber order information confidentially and failed to disclose to all subscribers that their confidential order information was being transmitted out of the dark pool to other affiliated Credit Suisse entities.³¹⁰ Moreover, Credit Suisse allegedly misrepresented to its clients that a certain feature called Alpha Scoring, used by its dark pool to characterize subscriber order flow, operated on a monthly basis and in an objective and transparent manner.³¹¹ However, Alpha Scoring included significant subjective elements and therefore, did not work in a transparent and objective manner, nor did it categorize all subscribers on a monthly basis.³¹² For example, Credit Suisse personnel used their judgment to subjectively classify Crossfinder subscribers into various groups and had discretion to determine which factors to consider when scoring. Among those factors were feedback from subscribers and observations of Credit Suisse personnel.³¹³ Finally, Credit Suisse failed to disclose that it operated a technology which informed two high frequency trading firms about existing orders that were submitted by customers, thereby enabling them to front-run orders.³¹⁴ As a result, the SEC’s orders found that Credit Suisse violated Section 17(a)(2) SA, Rules 301(b)(2), (5) and (10) of Regulation ATS, and Rules 602(b) and 612 of Regulation NMS.³¹⁵

g. In the Matter of Barclays Capital At the same time, on January 31, 2016, Barclays Capital, Inc. (Barclays), admitted making material misrepresentations in marketing and operating its dark pool,

 SEC, Press Release 2016 – 16, Barclays, Credit Suisse Charged With Dark Pool Violations (Jan. 31, 2016), https://www.sec.gov/news/pressrelease/2016 -16.html (last visited Sept. 25, 2018).  SEC, In the Matter of Credit Suisse Securities (USA) LLC, File No. 3 – 17078 (Jan. 31, 2016), para. 7, 9; Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 38.  SEC, In the Matter of Credit Suisse Securities (USA) LLC, File No. 3 – 17078 (Jan. 31, 2016), para. 11– 12.  SEC, In the Matter of Credit Suisse Securities (USA) LLC, File No. 3 – 17078 (Jan. 31, 2016), para. 12; SEC, Press Release 2016 – 16, Barclays, Credit Suisse Charged With Dark Pool Violations (Jan. 31, 2016), https://www.sec.gov/news/pressrelease/2016 -16.html (last visited Sept. 25, 2018).  SEC, In the Matter of Credit Suisse Securities (USA) LLC, File No. 3 – 17078 (Jan. 31, 2016), para. 44.  SEC, In the Matter of Credit Suisse Securities (USA) LLC, File No. 3 – 17078 (Jan. 31, 2016), para. 16.  SEC, In the Matter of Credit Suisse Securities (USA) LLC, File No. 3 – 17078 (Jan. 31, 2016), para. 66.

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Barclays LX, and agreed to settle charges for a USD 35 million penalty.³¹⁶ Barclays promoted its dark pool as a place with very little aggressive HFT to protect its subscribers from predatory trading and latency arbitrage.³¹⁷ However, in fact, the dark pool benefitted high-frequency traders by giving them the opportunity to exploit other customers in the dark pool without disclosing these facts to the other customers, but, rather, making false representations.³¹⁸ Barclays operated a service designed to categorize firms using the dark pool according to their aggressiveness (ranging from “most aggressive” to “least aggressive”), depending on certain aspects of their order flow, and provided each user with the option to prevent specific entities from trading against them, e. g. to block the most aggressive traders from interacting with them.³¹⁹ The main issue was that Barclays did not police the dark pool as promoted and conducted very little surveillance of the trading activity to ensure protection against predatory trading practices.³²⁰ Moreover, Barclays sometimes manually overrode the categorization of participants by moving customers from the most aggressive categories to the least aggressive.³²¹ As a result, customers that had opted to block trading with aggressive customers nonetheless continued to interact with them.³²² In addition, Barclays made false statements about the market data feeds it used to determine the NBBO and thus, to set the prices in the dark pool.³²³ Furthermore, Barclays misrepresented that it used more direct feeds from exchanges than it actually did.³²⁴ Using slower feeds from Securities Information Processors (SIPs) enables highfrequency traders to gain advantage from using faster, direct feeds from exchang-

 SEC, In the Matter of Barclays Capital Inc., File No. 3 – 17077 (Jan. 31, 2016); SEC, Press Release 2016 – 16, Barclays, Credit Suisse Charged With Dark Pool Violations (Jan. 31, 2016), https:// www.sec.gov/news/pressrelease/2016 -16.html (last visited Sept. 25, 2018). See also Mahoney/ Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 38 – 39.  SEC, In the Matter of Barclays Capital Inc., File No. 3 – 17077 (Jan. 31, 2016), para. 2, 20, 49.  SEC, In the Matter of Barclays Capital Inc., File No. 3 – 17077 (Jan. 31, 2016), para. 7, 10 – 12.  SEC, In the Matter of Barclays Capital Inc., File No. 3 – 17077 (Jan. 31, 2016), para. 22 et seqq.  SEC, Press Release 2016 – 16, Barclays, Credit Suisse Charged With Dark Pool Violations (Jan. 31, 2016), https://www.sec.gov/news/pressrelease/2016 -16.html (last visited Sept. 25, 2018); SEC, In the Matter of Barclays Capital Inc., File No. 3 – 17077 (Jan. 31, 2016), para. 6.  SEC, In the Matter of Barclays Capital Inc., File No. 3 – 17077 (Jan. 31, 2016), para. 7– 8, 29 et seqq.; Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 39.  SEC, In the Matter of Barclays Capital Inc., File No. 3 – 17077 (Jan. 31, 2016), 30 – 33; SEC, Press Release 2016 – 16, Barclays, Credit Suisse Charged With Dark Pool Violations (Jan. 31, 2016), https://www.sec.gov/news/pressrelease/2016 -16.html (last visited Sept. 25, 2018).  SEC, In the Matter of Barclays Capital Inc., File No. 3 – 17077 (Jan. 31, 2016), para 46 – 49.  SEC, In the Matter of Barclays Capital Inc., File No. 3 – 17077 (Jan. 31, 2016), para 11– 13.

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es.³²⁵ As a consequence of Barclay’s practice, HFT firms were able to apply predatory trading strategies and profit from latency arbitrage. By representing the dark pool as safe and with no risk for customers of being exploited by high-frequency traders, Barclays made material misrepresentations. Further, the failure to disclose to customers the operation of the service utilized to categorize traders and the manual amendments constituted an omission of material facts. Hence, according to the SEC’s cease-and-desist order, Barclays willfully violated Section 17(a)(2) SA and Rules 301(b)(2) and 301(b)(10) of Regulation ATS.³²⁶ However, again, the SEC did not find that Barclay’s services, i. e. the trader categorization and the option to block certain traders, were illegal.³²⁷

h. In the Matter of Deutsche Bank In its most recent enforcement action against a dark pool, the SEC charged Deutsche Bank Securities, Inc. (Deutsche Bank), for misleading clients about the performance of a core feature of its automated order router that primarily sent client orders to dark pools.³²⁸ Deutsche Bank agreed to admit wrongdoing and pay USD 18.5 million penalties to the SEC.³²⁹ According to the SEC’s Statement of Facts, Deutsche Bank, a registered broker-dealer, developed an order router, SuperX+, primarily for automatically routing equity orders primarily to dark pools.³³⁰ Deutsche Bank marketed SuperX+ as based on a routing algorithm called the “Dark Pool Ranking Model” (DPRM), which was described in the disclosure materials

 SIP is defined in 15 U.S.C. § 78c(a)(22)(A). For more details see above in section B.I.2.e.  SEC, In the Matter of Barclays Capital Inc., File No. 3 – 17077 (Jan. 31, 2016), para. 63. In addition the SEC found that Barclays violated Sec. 15(c)(3) SEA and Rules 15c3 – 5(b) and 15c3 – 5(c) (1)(i) (SEC’s Market Access Rule), which require the risk management controls and supervisory procedures of a broker or dealer with or providing market access to be reasonably designed to prevent the entry of orders that exceed appropriate pre-set credit or capital thresholds in the aggregate for each customer and the broker or dealer by rejecting orders if such orders would exceed the applicable credit or capital thresholds.  This argument is also made by Thelen, Dark Pools – Schattenbörsen im Lichte US-amerikanischer, europäischer und deutscher Kapitalmarktregulierung (Dark Pools – Dark Trading Platforms in the Light of US-American, European and German Capital Market Regulation), 140.  See SEC, Press Release 2016 – 264, Deutsche Bank Settles Charges of Misleading Clients About Order Router (Dec. 16, 2016), https://www.sec.gov/news/pressrelease/2016 -264.html (last visited Sept. 25, 2018).  SEC, Press Release 2016 – 264, Deutsche Bank Settles Charges of Misleading Clients About Order Router (Dec. 16, 2016), https://www.sec.gov/news/pressrelease/2016 -264.html (last visited Sept. 25, 2018).  SEC, In the Matter of Deutsche Bank Securities Inc., File No. 3 – 17730 (Dec. 16, 2016), para. 18.

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offered to clients and potential clients as SuperX+’s “quantitative core”.³³¹ The DPRM was designed to rank venues based on execution quality and liquidity of venues, and then to route orders to eligible venues that, according to the measures, were best suited for the specific customer orders.³³² However, due to a coding error, SuperX+ did not function properly and failed to update the DPRM, so that the rankings were based on stale data.³³³ According to the SEC’s order, this failure caused at least three dark pools – including Deutsche Bank’s own dark pool SuperX – to be ranked improperly high and hence, to receive millions of orders that would have been sent elsewhere if the system was operating as described.³³⁴ Moreover, investigations revealed that after adding new venues to the system, Deutsche Bank’s personnel manually overrode the rankings and assigned fill rates for new venues, both based on the personnel’s subjective judgment that turned out to be inconsistent with the venues’ actual performance.³³⁵ However, Deutsche Bank did not inform clients or potential clients about the failure of SuperX+ and the DPRM but continued to provide the marketing materials promoting the use of the system without making corrections regarding its operation or the supplementation of new venues based on subjective judgment.³³⁶ Thus, Deutsche Bank’s marketing materials accordingly failed to reflect the actual operation of SuperX+ and hence, contained false statements about the

 SEC, In the Matter of Deutsche Bank Securities Inc., File No. 3 – 17730 (Dec. 16, 2016), para. 19, 32; cf. Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 29.  SEC, In the Matter of Deutsche Bank Securities Inc., File No. 3 – 17730 (Dec. 16, 2016), para. 20 – 23, 28; cf. Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 29.  SEC, In the Matter of Deutsche Bank Securities Inc., File No. 3 – 17730 (Dec. 16, 2016), para. 33.  SEC, In the Matter of Deutsche Bank Securities Inc., File No. 3 – 17730 (Dec. 16, 2016), para. 31, 44 (“Between February 19, 2013, and February 5, 2014, Deutsche Bank sent 1.7 million orders marked as passive, representing 197.9 million shares, to the first dark pool, and 1.9 million orders marked as neutral, representing 327 million shares, to the second dark pool.”); SEC, Press Release 2016 – 264, Deutsche Bank Settles Charges of Misleading Clients About Order Router (Dec. 16, 2016), https://www.sec.gov/news/pressrelease/2016 -264.html (last visited Sept. 25, 2018).  SEC, In the Matter of Deutsche Bank Securities Inc., File No. 3 – 17730 (Dec. 16, 2016), para. 36 – 38; cf. Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 29.  SEC, In the Matter of Deutsche Bank Securities Inc., File No. 3 – 17730 (Dec. 16, 2016), para. 35, 39.

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methodology used for order routing.³³⁷ The SEC’s order found that due to materially misleading statements and omissions of fact, Deutsche Bank violated Section 17(a)(2) SA, and that due to the failure to amend its Form ATS with respect to the material change to the operation of the system, it also violated Rule 302(b)(2) of Regulation ATS.³³⁸

3. Conclusion In summary, the main allegations by the SEC were that the dark pools did not comply with regulatory requirements regarding the disclosure about their material operation and the provision of procedure to protect their customers, especially against exploitation by high frequency traders and conflicts of interest. The cases demonstrate that there are two primary issues market participants are concerned with: (1) information leakage, and (2) front-running.³³⁹ Regarding the assessment of the current regulation the question is whether these will completely be eliminated if the dark pool operators totally comply with all the regulations. Assuming that this is the case, the next question is whether there is still an actual need for more or stricter regulation concerning these issues or whether the regulators’ focus should shift. Future development will show if the high fines paid by the dark pool operators in the recent enforcement actions will deter them and other dark pools from violating the regulations and thereby minimize the concerns and risks for other market participants. It will also show whether the US approach towards the regulation of dark pool trading serves its purpose to reestablish a level playing field and assure compliance with the securities laws, in order to restore public confidence in the markets. As the next part establishes, this has been widely disputed. Although most of the actions by the SEC against dark pools were settled by the dark pools, the unwaivering determination of the SEC to prosecute violations in the dark sector and the sheer amount of the fines that the dark pool operators were willing to pay demonstrate that this may be a successful way to police the operation of dark pools.

 SEC, In the Matter of Deutsche Bank Securities Inc., File No. 3 – 17730 (Dec. 16, 2016), para. 7, 15; Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 29.  SEC, In the Matter of Deutsche Bank Securities Inc., File No. 3 – 17730 (Dec. 16, 2016), para. 52.  Cf. Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 337.

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IV. Critique and Conclusion on US Regulation Although the regulators in the US made efforts to address many of the issues involved in dark trading and to find a balance between facilitating competition on the one hand and integrating trading venues into a National Market System on the other hand, the regulatory framework does not provide an entirely effective and efficient solution. First, the SEC’s approach is highly criticized. The categorization of trading venues only as either national exchanges or broker-dealers does not efficiently reflect the broad range of different venues and may likely fail to capture large segments of the trading industry by the regulatory framework. Further, the differentiation in regulatory requirements for those two categories does not reflect and recognize the functional similarities.³⁴⁰ Although the enactment of Regulation ATS was an attempt to integrate ATSs into the National Market System, most of the regulations only apply to ATSs operating above the threshold of five percent of the average daily trading volume of a single security. Thus, any ATS operating below this threshold is not subject to the requirements and is not covered by the regulatory regime. This weakness drastically inhibits the effects intended by the regulations. With Regulation NMS the SEC aimed at further integrating ATSs and improving, in particular, the transparency regime, fair access requirements, and the consolidation of data. As previously pointed out in detail, Regulation NMS is very controversial and harshly criticized.³⁴¹ Still, the major weakness is that the five percent threshold limits the scope of application. Further, Regulation NMS lacks sufficient safeguards to inhibit information leakage and front-running and thus, does not protect investors from harmful HFT strategies.³⁴² Because the regulation fails to specify the speed of the Securities Information Processors (SIP)³⁴³ that collect data to calculate the NBBO, high-frequency traders can entirely circumvent the regulations.³⁴⁴ Apparently, the technology used to perform calculations for the SIP was outdated, so that high-frequency traders created

 Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 51 (“Should there be multiple different regulatory statuses for trading venues that are becoming increasingly functionally similar?”).  See above in section B.I.2.e.  Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 357.  Defined in 15 U.S.C. Sec. 78c(a)(22)(A).  Lewis, Flash Boys, 97– 98; Marciello, 49 Suffolk U. L. Rev. (2016), 163, 174; Patterson, Dark Pools, 49 – 50, 202– 203.

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their own, much faster SIP and therefore are able to get the information milliseconds faster than ordinary investors.³⁴⁵ The recent proposals by the SEC also do not adequately address the HFT issues and, instead, will increase them. For instance, the proposal to provide realtime disclosures of all executed trades³⁴⁶ will likely facilitate front-running and information leakage.³⁴⁷ Critics claim that it is unclear whether and to what extent the nature and timing of the reporting of dark trading data is economically significant and suggest that post-trade reporting, including specific dark pool information, should be delayed to reduce the timing advantage of high-frequency traders.³⁴⁸ A more general critique posits that the current regulations are not based on sufficient economic evidence and that any restrictions on dark trading, including the latest proposals by the SEC, would require a deeper empirical analysis that would study, for instance, whether increased dark liquidity has a negative effect on the lit sector and market quality overall.³⁴⁹ Further, considering that a major incentive for dark trading is the need of institutional traders to shield their trading activity from predatory trading strategies, recommendations are made to focus on fair access throughout the market as otherwise, any solution will only be “a patch for a larger problem”.³⁵⁰ Therefore, proposals by the SEC to lower the trading volume threshold do not benefit the main goal to reduce potential risks, but inhibit dark trading. It is not clear how such a regulatory step would appropriately address the issues. Rather, regulators should encourage the interconnectedness between the dark sector and the lit sector and enhance supervision of dark pools and enforcement actions to prosecute violations of the current regulations.³⁵¹

 Lewis, Flash Boys, 97– 98; Marciello, 49 Suffolk U. L. Rev. (2016), 163, 174; Patterson, Dark Pools, 202– 203, 227– 228.  SEC, Proposed Rules and Amendments, Regulation of Non-Public Trading Interest, Release No. 60997 (Nov. 13, 2009), Vol. 74 Fed. Reg. (Nov. 23, 2009), 61208, 61219.  Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 355.  Hintz, 13 DePaul Bus. & Com. L. J. (2015), 329, 355 proposing an “end-of-the-week reporting”.  Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 51– 52; Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 589. See also Klock, 51 Fla. L. Rev. (1999), 753 – 797, 784, 792– 793 arguing that the regulatory environment of Regulation ATS does not reflect the economic reality, that “Regulation ATS appears to be based on wild speculation” and that the SEC ignored economic evidence.  Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 590.  Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 590.

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C. Regulation of Dark Trading in the EU The main difference between the US regulatory regime and the EU regulatory regime is that the US securities market has always been treated as one single market whereas the EU market comprises several individual markets of the Member States each with its own regulatory autonomy. Thus, the main aim – and at the same time the greatest challenge – of the EU regulation is to harmonize the different regulatory frameworks and create a level playing field among the markets, eventually, to construct a single integrated market.³⁵² This regulatory approach of harmonization is justified because the different markets interact with each other and, in times of globalization, keep getting intertwined even stronger. As a result, the various market participants and transactions easily move across the borders, thereby increasing the potential for harmful cross-border effects, including cross-border crimes and systemic risks, which may lead to market failure and an overall negative impact on the market.³⁵³ Given that the increasing cross-border activities in the securities market can impose a threat to the core objectives of market regulation, there is reasonable and sound justification for regulatory intervention. There are two degrees of harmonization: (1) maximum harmonization providing that national laws by the Member States cannot undermine or deviate from the regulatory content and scope, or (2) minimum harmonization providing that the regulations contain only a minimum of requirements that must be adopted by the Member States and may be exceeded.³⁵⁴ In achieving the regulatory aims and, in particular, harmonization, the EU legislator has the discretion to choose between several tools of which two are particularly important: (1) directives which have to be transposed into national laws and provide some degree of implementation flexibility, and (2) regulations which are self-executing, applying directly in all Member States, and which are immediately enforceable.³⁵⁵ In the past, the EU legislator primarily used direc-

 Cf. Moloney, EU Securities and Financial Markets Regulation, 8 – 9; Veil, Sources of Law and Principles of Interpretation, in: Veil, European Capital Markets Law, 65, 66. See also Art. 3(3) Treaty on European Union (TEU) and Art. 26 Treaty on the Functioning of the European Union (TFEU) providing the fundamentals for EU securities regulation to construct a single market.  Moloney, EU Securities and Financial Markets Regulation, 19.  Walla, Process and Strategies of Capital Markets Regulation in Europe, in: Veil, European Capital Markets Law, 39, 54.  See Art. 288 TFEU; Veil, Sources of Law and Principles of Interpretation, in: Veil, European Capital Markets Law, 65, 65, 80.

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tives as they provide for sufficient leeway for the Member States to reconcile the national specifications and differences, making it easier for the EU legislator to find a compromise during the negotiations and making it easier for the Member States to implement the new rules in their existing regulatory frameworks.³⁵⁶ However, the location of regulatory power at EU level rather than at member state level bears another burden: despite rule-making in the securities market being prone to risks and failures in general, effective regulation at EU level is even more difficult as the EU law-making process is very complex, multilayered and often obstructed by political disputes, due to the deeply rooted institutional and cultural differences among the Member States.³⁵⁷ Therefore, EU regulation is often a compromise reflecting these differences and the outcome of very longlasting negotiations. Hence, it is not surprising that, although the regulation of alternative trading venues in the EU started off in 1999, it took until the end of 2003 to implement the first regulations within the Member States.³⁵⁸ These regulations were based on the “Standards for Alternative Trading Systems” established by the former Committee of European Securities Regulators (CESR).³⁵⁹ It contained a definition of ATSs and common standards, including the requirements for ATSs (1) to notify the competent authorities about the price formation process, rules of the system, participants and instruments trades, (2) to comply with minimum transparency requirements, (3) to make certain reports to the competent authorities, and (4) to prevent market abuse.³⁶⁰

 Cf. Walla, Process and Strategies of Capital Markets Regulation in Europe, in: Veil, European Capital Markets Law, 39, 53.  Moloney, EU Securities and Financial Markets Regulation, 21.  Kumpan, Die Regulierung außerboerslicher Wertpapierhandelssysteme im deutschen, europaeischen und US-amerikanischen Recht (The Regulation of Over-the-Counter Trading Systems in German, European and US Law), 170 et seqq.; CESR, First Interim Report, CESR/03 – 414b (Dec. 2003), 6. The earlier Investment Services Directive (ISD), Directive 93/22/EEC, published in Official Journal of the European Union, L 141 (June 1, 1993), marks the starting point of European regulation of investment firms and regulated markets, but it did not address alternative trading venues.  CESR, Standards for Alternative Trading Systems, CESR/02– 086b (July 2002). See also CESR, Press Release, CESR/02– 117, CESR adopts final standards for ATSs and final conduct of business rules to protect retail and professional investors in Europe (July 8, 2002), https:// www.esma.europa.eu/sites/default/files/library/2015/11/02_117.pdf (last visited Sept. 25, 2018).  CESR, Standards for Alternative Trading Systems, CESR/02– 086b (July 2002). A detailed assessment is provided by Kumpan, Die Regulierung außerboerslicher Wertpapierhandelssysteme im deutschen, europaeischen und US-amerikanischen Recht (The Regulation of Over-the-Counter Trading Systems in German, European and US Law), 170 – 181.

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These standards, however, were not legally binding and thus, could not sufficiently provide for a harmonized regime governing the new types of trading venues and taking into account the emerging cross-border transactions while ensuring investor protection.³⁶¹ To further enhance the harmonization of the different regulatory regimes of the different Member States, the EU regulator enacted the 2004 Markets in Financial Instruments Directive (MiFID I) in 2007 pursuing an overall facilitative approach to liberalize order execution and promote competition.³⁶² It constituted an important cornerstone of the regulation of trading venues and legal persons engaged in the investment business by providing investment services to third parties or performing investment activities on a professional basis (“investment firms”).³⁶³ However, as the financial crisis of 2007– 2009 hit the global securities markets, the EU legislator was forced to take actions to enhance market stability and investor protection. Thus, while reviewing MiFID I, the focus shifted to maximum harmonization and a rather prescriptive and regulatory approach. Since then, the EU legislator took more advantage of regulations as a regulatory tool to avoid implementation risks.³⁶⁴ For instance, under the new regime, the second Directive on Markets in Financial Instruments (MiFID II)³⁶⁵, which accommodates some degree of implementation flexibility, is accompanied by the Markets in Financial Instruments Regulation (MiFIR)³⁶⁶, which addresses the matters on which uniformity of application is essential such as transparency and distribution of trading data.³⁶⁷

 Cf. Gadinis, 3 Va. L. & Bus. Rev. (2008), 311– 356, 332. See Busch/Ferrarini, Who’s Afraid of MiFID II?: An Introduction, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 1.01– 1.57, 1.04, 1.06.  Directive 2004/39/EC of 21 April 2004 on markets in financial instruments (MiFID I), comprising the level 1 Directive 2004/39/EC, the level 2 Directive 2006/73/EC and Regulation 1287/ 2006. See Rec. 1, 5 MiFID I.  Cf. Moloney, EU Securities and Financial Markets Regulation, 35. The definition of investment firms is provided in Art. 4(1) Nr. 1 MiFID I (see also Art. 4(1) Nr. 1 MiFID II).  Moloney, EU Securities and Financial Markets Regulation, 40; Walla, Process and Strategies of Capital Markets Regulation in Europe, in: Veil, European Capital Markets Law, 39, 53; Veil, Sources of Law and Principles of Interpretation, in: Veil, European Capital Markets Law, 65, 65 – 66.  Directive 2014/65/EU of 15 May 2014 on markets in financial instruments (MiFID II).  Regulation (EU) No 600/2014 of 15 May 2014 on markets in financial instruments (MiFIR).  See also Moloney, EU Securities and Financial Markets Regulation, 40.

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This new regulatory approach was followed by a reform in the legislative procedure through the amendment of the so-called ‘Lamfalussy Process’.³⁶⁸ Notably, it empowers the European Securities and Markets Authority (ESMA) to develop draft Regulatory Technical Standards (RTS) and Implementing Technical Standards (ITS) and advise the EU Commission on the technical details when adopting the delegated acts. Further, ESMA provides recommendations and guidelines and compares regulatory practice to ensure consistent implementation and application of the adopted rules.³⁶⁹ In contrast to the developments on the regulatory level towards increased harmonization and integration, supervision and enforcement is still primarily a matter of national law and remains with the Member States rather than with ESMA.³⁷⁰ Consequently, the regulatory concepts of the national supervision vary greatly among the Member States, but the EU regulator is taking steps to enhance harmonization also in regard to the national authorities’ sanctioning power.³⁷¹ The next part outlines the two major cornerstones of EU trading venue regulation that primarily shaped the structure of the EU securities market and had a great impact on the development of dark trading:³⁷² (1) the 2007 MiFID establishing the foundation of the trading venue regulation, and (2) the 2014 MiFID II and the accompanying MiFIR reshaping the former regime and taking the trading venue regulation to the next level.

I. The Original MiFID of 2004 The first significant steps towards a harmonized regulatory framework that governed trading venues were made with the enactment of the original 2004 Market

 The legislative procedure by named after Baron Alexandre Lamfalussy, chair of the Committee of Wise Men on the Regulation of European Securities Markets. This four-level approach was adopted by the Stockholm European Council in March 2001 aiming at more effective securities markets regulation. Further details are provided for instance by Moloney, 52 ICLQ (2003), 509. See also below in section C.II.1.  Busch/Ferrarini, Who’s Afraid of MiFID II?: An Introduction, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 1.01– 1.57, 1.02 note 3. See details below in section C.II.2.  Walla, Capital Markets Supervision in Europe, in: Veil, European Capital Markets Law, 133, 135; Moloney, EU Securities and Financial Markets Regulation, 499 et seqq., 965 et seqq. See further below in section C.II.2.c.  Walla, Capital Markets Supervision in Europe, in: Veil, European Capital Markets Law, 133, 135– 136.  A detailed overview and assessment of the EU regulation of trading venues and its development is provided by Moloney, EU Securities and Financial Markets Regulation, 425 et. seqq.

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in Financial Instruments Directive (MiFID I) in 2007.³⁷³ It provides a comprehensive set of common rules encompassing “the full range of investor-oriented activities” to offer a high level of investor protection and allow investment firms to operate throughout the EU market.³⁷⁴ Its superior goal was to boost EU-wide competition among the trading venues rather than to simply facilitate market access across the EU. It also served to enhance innovation, investor choice and lower prices by establishing an integrated, single European market for investment services.³⁷⁵ The main challenge in designing MiFID I was to find a balance between promoting competition among the trading venues and providing an appropriate level of investor protection in order to achieve the goal of creating a harmonized framework to safeguard the efficiency and integrity of the market. The former was to be achieved by establishing a regulatory environment that was not too prescriptive and flexible enough to adapt rapidly to changes, while the latter demanded for a precise and uninterpretable set of rules.³⁷⁶ The EU regulator chose a facilitative approach to liberalize order execution and implemented it by means of venue classification,³⁷⁷ in order to enable different types of trading venues to compete for order flow and liquidity (within the market under a common set of rules) without “jeopardizing the orderly and efficient operation of the EU securities market system, or the interests of issuers and investors”.³⁷⁸

 Directive 2004/39/EC on markets in financial instruments of April 2004 (MiFID I), published in Official Journal of the European Union, L 145/1 (April 4, 2004).  Rec. 2 MiFID I; O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 110.  EU Commission, Investment services and regulated markets – Markets in financial instruments directive (MiFID), https://ec.europa.eu/info/business-economy-euro/banking-and-finance/ financial-markets/securities-markets/investment-services-and-regulated-markets-markets-finan cial-instruments-directive-mifid_en (last visited Sept. 25, 2018); Gadinis, 3 Va. L. & Bus. Rev. (2008), 311– 356, 332; Davies/Dufour/Scott-Quinn, The MiFID: Competition in a New European Equity Market Regulatory Structure, in: Ferrarini/Wymeersch, Investor Protection in Europe, 163, 165; Moloney, EU Securities and Financial Markets Regulation, 437.  Rec. 2, 5, 31, 71 MiFID I; Davies/Dufour/Scott-Quinn, The MiFID: Competition in a New European Equity Market Regulatory Structure, in: Ferrarini/Wymeersch, Investor Protection in Europe, 163, 165, 191. See also Rec. 2, 31 MiFID I.  Rec. 5, 6 MiFID I; Moloney, EU Securities and Financial Markets Regulation, 435.  Davies/Dufour/Scott-Quinn, The MiFID: Competition in a New European Equity Market Regulatory Structure, in: Ferrarini/Wymeersch, Investor Protection in Europe, 163, 187– 188.

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1. Main Regulatory Achievements In respect of the overarching goal, the primary achievements were (1) the abolition of the concentration rule, (2) the design of a regulatory framework covering alternative trading systems and internalization, and (3) the establishment of an enhanced transparency regime.³⁷⁹

a. Abolition of the Concentration Rule The first major change imposed by MiFID I was the abolition of the so-called concentration rule that traditionally had been in place in various Member States,³⁸⁰ and under which securities were to be traded exclusively on national exchanges, by requiring Member States to allow the internalization of orders.³⁸¹ Thereby, MiFID I promoted competition and facilitated the structural change from consolidated to fragmented markets.³⁸²

b. New Categories of Trading Venues Acknowledging the growing number of trades executed over-the-counter and in particular through internalization, MiFID I introduced new categories of trading venues that ought to be regulated similarly in order to create a level playing field

 Cf. Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.39 et seqq.; Gresse, Effects of Lit and Dark Market Fragmentation on Liquidity (Mar. 2016), 13; Di Febo/Angelini, 26 Curr. Pol. & Econ. Eur. (2015), 267, 268 – 269. A more detailed overview is presented by Moloney, EU Securities and Financial Markets Regulation, 435 et seqq.  The ‘concentration rule’ is a provision based on Art. 14(3) of the 1993 Investment Services Directive (Directive 93/22/EEC, published in Official Journal of the European Union, L 141 (June 11, 1993) which permitted a Member States to require that domestic transactions must be carried out on a regulated market. See also Davies/Dufour/Scott-Quinn, The MiFID: Competition in a New European Equity Market Regulatory Structure, in: Ferrarini/Wymeersch, Investor Protection in Europe, 163, 179 – 187; Koendgen/Theissen, Internalisation under the MiFID: Regulatory Overreaching or Landmark in Investor Protection?, in: Ferrarini/Wymeersch, Investor Protection in Europe, 271, 271. Germany, for example, implemented this rule in § 22 BoersG in its former version, effective until Oct. 31, 2007.  See Rec. 2, 5, 6, 44 MiFID I, Art 20, 24 MiFID I; cf. Ferrarini/Recine, The MiFID and Internalisation, in: Ferrarini/Wymeersch, Investor Protection in Europe, 235, 237; O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 110 – 111.  Gresse, Effects of Lit and Dark Market Fragmentation on Liquidity (Mar. 2016), 13; Ferrarini/ Recine, The MiFID and Internalisation, in: Ferrarini/Wymeersch, Investor Protection in Europe, 235, 237. Cf. Rec. 2 MiFID I.

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and assure the same level of investor protection.³⁸³ MiFID I classified the venues among three types: (1) Regulated Markets (RMs), (2) Multilateral Trading Facilities (MTFs), and (3) Systematic Internalizer (SI).³⁸⁴ The category ‘regulated markets’ covered multilateral, non-discretionary trading venues which brings together multiple third-party buying and selling interests in financial instruments in accordance with non-discretionary rules.³⁸⁵ Trading venues were classified as RMs not by law but only if they applied for it and were granted authorization by the competent authority.³⁸⁶ RMs were subject to the highest level of regulation, including detailed pre-trade and post-trade transparency requirements and organizational rules aimed at preventing conflicts of interest.³⁸⁷ The second category, ‘multilateral trading facility’, applied to multilateral systems which bring together multiple third-party buying and selling interests in financial instruments in accordance with non-discretionary rules.³⁸⁸ Apparently, there was no significant difference between RMs and MTFs. Trading venues were classified as MTFs by law if they met the requirements and did not opt for authorization as an RM.³⁸⁹ The primary purpose of introducing this category was to capture any form of organized trading venue as distinguished from OTC venues.³⁹⁰ MTFs also had to comply with rules governing the MTF trading process and the monitoring of compliance with the MTF’s rules. Further, they were subject to the same pre-trade and post-trade transparency rules that applied to RMs with respect to shares admitted to trading on an RM.³⁹¹ The third category, ‘systematic internalizer’, was an attempt to capture a subset of the OTC sector. It covers investment firms which on an organized, frequent and systematic basis, deal on own account by executing client orders outside an

 Rec. 5, 6 MiFID I. Cf. Ferrarini/Recine, The MiFID and Internalisation, in: Ferrarini/Wymeersch, Investor Protection in Europe, 235, 237– 238.  See the definitions in Art. 4(1) MiFID I. Cf. Ferrarini/Recine, The MiFID and Internalisation, in: Ferrarini/Wymeersch, Investor Protection in Europe, 235, 237; Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.40; Gresse, Effects of Lit and Dark Market Fragmentation on Liquidity (Mar. 2016), 14. The terminology in comparison to the equivalents used in the US context is explained in Ch. 1 (A.II.2., III.). See also Gadinis, 3 Va. L. & Bus. Rev. (2008), 311– 356, 333 – 334.  Art. 4(1)(14) MiFID I.  Art. 36 MiFID I. See also Moloney, EU Securities and Financial Markets Regulation, 439.  Moloney, EU Securities and Financial Markets Regulation, 438 – 439.  Art. 4(1)(15) MiFID I.  Moloney, EU Securities and Financial Markets Regulation, 439.  Moloney, EU Securities and Financial Markets Regulation, 439.  Art. 29(1), 30(1) MiFID I; Moloney, EU Securities and Financial Markets Regulation, 439.

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RM or MTF.³⁹² MiFID I treated SIs like “mini-exchanges” making them subject to similar rules, including the transparency regime.³⁹³ In addition, since they act as investment firms, SIs were also subject to a range of conduct-of-business rules governing the decision to internalize a client order.³⁹⁴ All other forms of order execution fell within the OTC sector as a ‘catch-all venue’ that was not explicitly defined in MiFID I and only mentioned once in Recital 53 which describes certain characteristics of OTC trades.³⁹⁵ MiFID I did not directly address OTC trading but provided rules for investment-services which also applied to investment firms, not classified as SIs, that were engaged in OTC trading. However, overall trading in the OTC sector remained largely unregulated.

c. Enhanced Transparency Regime MiFID I further enhanced overall transparency of transactions by establishing a transparency regime that also covered and integrated certain OTC trades if they were executed by SIs.³⁹⁶ The transparency regime was accompanied by a data publication and data consolidation regime. Overall, MiFID I established a set of rules for the disclosure of pre-trade data, consisting of information about current trading opportunities in regulated financial instruments, and the publication of post-trade data, consisting of details of completed transactions in regulated financial instruments.³⁹⁷ These rules similarly applied to RMs, MTFs, and SIs as well as to a limited extent to other OTC venues.³⁹⁸ Depending on their market model,³⁹⁹ RMs and MTFs were required to make public the current bid and offer prices and the depth of trading interests at these

 Art. 4(1)(7) MiFID I.  Gresse, Effects of Lit and Dark Market Fragmentation on Liquidity (Mar. 2016), 14.  See in particular Art. 19 MiFID I; Moloney, EU Securities and Financial Markets Regulation, 440.  Rec. 53 MiFID I. Accordingly OTC trades are typically ad hoc and irregular and carried out with wholesale counterparties. See also Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.44.  Gresse, Effects of Lit and Dark Market Fragmentation on Liquidity (Mar. 2016), 13 – 14.  Gresse, Effects of Lit and Dark Market Fragmentation on Liquidity (Mar. 2016), 14; O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 110.  Gresse, Effects of Lit and Dark Market Fragmentation on Liquidity (Mar. 2016), 14; O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 110.  Those market models are: continuous auction order book trading systems; quote-driven trading systems; periodic auction trading systems, and hybrid systems with characteristics of

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prices in respect of shares admitted to trading on an RM (pre-trade transparency), unless exemptions apply,⁴⁰⁰ and to make public the price, volume and time of the transactions executed in respect of such shares (post-trade transparency).⁴⁰¹ The publication had to be made on reasonable commercial terms and on a continuous basis during normal trading hours in regard to pre-trade data, and as close to real time as possible in regard to post-trade data.⁴⁰² Likewise, SIs that were dealing for sizes up to standard market size⁴⁰³ were required to publish on a regular and continuous basis pre-trade data, i. e. firm quotes in shares admitted to trading on an RM for which there was a liquid market.⁴⁰⁴ An exemption applied to those SIs that were only dealing in sizes above standard market size, i. e. large block trades. Further, all investment firms, SIs as well as other investment firms operating in the OTC sector, were subject to posttrade transparency requirements to the same extent as were RMs and MTFs.⁴⁰⁵ However, the EU Regulation No. 1287/2006 of August 10, 2006⁴⁰⁶ accompanying MiFID I also provided exemptions from the pre-trade transparency requirements for RMs and MTFs. According to Articles 29(2) (for MTFs), 44(2) (for RMs) MiFID I, the national authorities could waive the obligation to provide pre-trade transparency for operators of trading venues based either on the mar-

multiple market models. See Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.45 et seqq.  Pursuant to Art. 29 and 44 MiFID I. Exemptions apply in case the competent authorities granted a waiver as provided in the second subparagraph of each Article. Cf. O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 111.  Pursuant to Art. 30 and 45 MiFID I.  Cf. Art. 29(1), 30(1), 44(1), 45(1) MiFID I.  As defined in Art. 27(1) MiFID I the standard market size for each class of shares shall be a size representative of the arithmetic average value of the orders executed in the market for the shares included in each class of shares.  Art. 27(1) MiFID I. The requirement of a “liquid market” reflects the aim of MiFID I to prevent that liquidity migrates from public exchanges to other trading venues under non-transparent conditions. See Mutschler, Internalisierung der Auftragsausfuehrung im Wertpapierhandel (Internalization of Order Execution in Securities Trading), 225. According to Art. 22 of Regulation 1287/2006/EC (accompanying MiFID I), a market is considered liquid wen a share is traded on a daily basis with a free float exceeding EUR 500 million. See also Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.50.  Art. 28, 30 MiFID I.  Regulation 1287/2006/EC of 10 August 2006 published in Official Journal of the European Union, L 241/1 (Sept. 2, 2006).

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ket model or the type and size of the orders.⁴⁰⁷ The waivers set forth in Article 18 of Regulation 1287/2006/EC applied to (1) venues operating as price reference systems which execute trades at a price based on a primary exchange price, (2) venues that formalize negotiated transactions, (3) reserve or iceberg orders held on an RM or MTF, and (4) large-in-scale orders.⁴⁰⁸ Under the reference price waiver trading venues were exempt which determine the execution price according to a reference price generated by another system, where that reference price is widely published and is regarded by market participants as a reliable reference price, for instance the EBBO or PBBO.⁴⁰⁹ Subject to the negotiated transaction waiver were trading venues which formalize negotiated transactions provided that transactions take place at or within the current volume-weighted spread or is subject to conditions other than the current market price of the financial instrument.⁴¹⁰ The term ‘negotiated transaction’ is further specified in Article 19 of Regulation 1287/2006/EC. Accordingly, it shall mean a transaction involving members or participants of an RM or MTF which is negotiated privately but executed within the RM or MTF and the parties either deal on own account or act for the account of a client. The third waiver applied to certain order types, including reserve and iceberg orders,⁴¹¹ that are held in an order management facility maintained by an RM or MTF pending those orders being disclosed to the market.⁴¹² The disclosure usually depends on a certain event or the fulfillment of specific conditions triggering their execution so that they are transparent only post-trade. Finally, the large-in-scale (LIS) waiver provided an exemption for orders that are deemed larger than the average market size, e. g. block trades. The size of or Cf. O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 111; Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.52.  See also O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 111– 112; Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.53 – 14.58. More details on the waiver regime are provided below in section C.II.3.d. under the current MiFID II/MiFIR regime.  Art. 18(1)(a) Regulation 1287/2006/EC. See the definitions of EBBO and PBBO in Ch. 1 (A.II.1, III.2.a., B.I.2.a.). Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.53. Many OTC venues executed eligible orders against each other at the midpoint of the reference price applying volume/time priority.  Art. 18(1)(b) Regulation 1287/2006/EC. Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.55; ComertonForde, Shedding light on dark trading in Europe (Aug. 2017), 2.  Those orders are referred to as dark orders. See Ch. 1 (A.III.1.) for further explanation.  Art. 18(2) Regulation 1287/2006/EC. Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.56; Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 2.

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ders qualifying as ‘large in scale’ depends on the average daily turnover in a particular stock in comparison to orders of a “normal market size”.⁴¹³ The minimum size necessary to be considered as ‘large-in-scale’ is provided in Table 2 in Annex II of Regulation 1287/2006/EC, starting off at 50,000 for an average daily turnover below 50,000 EUR. Any orders subject to one of these waivers remained hidden.⁴¹⁴ Thus, trading venues operating as reference price systems or executing only large block trades were exempt from pre-trade transparency requirements and did not have to disclose information about the respective orders.

2. Remaining Gaps and New Challenges Although the primary goals to promote competition among the different markets and trading venues and to liberalize order execution have been achieved and competition increased after the introduction of MTFs reducing overall transaction costs, it also led to some unintended consequences and caused new challenges. First, the venue classification mechanism turned out to be less efficient and effective in categorizing trading venues and capturing OTC trading. One issue was that, although the trading functionalities provided by RMs and by MTFs did not actually differ, the regulatory framework governing their operation and trading on these venues was not entirely uniform causing regulatory arbitrage.⁴¹⁵ Another major issue was that MiFID I did not directly address OTC venues. The attempt to cover a bigger subset of the OTC sector by the SI category failed. In practice, only a limited number of firms adopted the SI business model and a large number of OTC trades were executed in other forms than through systematic internalization.⁴¹⁶ The main concern of investment firms to be classified as an SI was that this category was subject to a transparency regime like RMs and MTFs, however, their operation was significantly different. While the operators of  Art. 20 Regulation 1287/2006/EC. Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.57.  Cf. Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.58.  Moloney, EU Securities and Financial Markets Regulation, 439; EU Commission, 2011 MiFID II/MiFIR Proposals Impact Assessment, SEC (2011) 1226 (Oct. 20, 2011), 10.  Cf. Moloney, EU Securities and Financial Markets Regulation, 442– 443; Cave, New Shades On Way for EU Dark Pool Trading, Rosenblatt Securities Inc. (Feb. 2, 2015), http://www.rblt.com/ news_details.aspx?id=265 (last visited Sept. 25, 2018). There are only 11 registered SIs in the EU with a total market share well below 2 percent. See Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.43.

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RMs and MTFs provide platforms where orders interact and thus, would not be directly affected by the disclosure, SIs are firms that execute trades against their proprietary capital and therefore, would be exposed to great risk of strategic behavior by other traders.⁴¹⁷ Hence, the SI business model was extremely unattractive and investment firms tried to avoid being designated as SIs and rather operate as another form of OTC venue with the result that the number of SIs was and remained insignificant.⁴¹⁸ The second unintended outcome of the MiFID I regime was the fragmentation of the market, making it difficult to collect trade data and thus, causing a lack of transparency.⁴¹⁹ Whereas the enhanced transparency regime had been predicted to provide greater connectivity in data retrieval and overall improvement in data quality and consolidation, it was not able to overcome and prevent this lack of transparency. Rather, it resulted in the creation of several trade reporting facilities (TRFs), which separately published different trading data, that was not standardized and thus, not comparable.⁴²⁰ Further, the hazardous extent of market fragmentation was reflected in the significant amount of dark trading. MiFID I facilitated this development in two ways: First, it allowed for exemptions from pre-trade transparency in form of waivers that applied to organized venues and certain order types and, second, it did not specifically address OTC trading and left a loophole for investment firms to escape to the unregulated dark sector.⁴²¹ Thus, aiming at the benefits of operating in the dark and being exempt from comprehensive transparency regulations, many operators of trading venues and investment firms either sought to meet the requirements provided under Articles 29(2), 44(2) and Article 27 MiFID I (above standard market size), or adapted their business models to avoid being classified as RM/MTF or SI, and thus, to fall within the OTC sector. Consequently, a significant amount of executions of not only large institutional but even more retail size orders takes place

 Moloney, EU Securities and Financial Markets Regulation, 440.  Cf. Moloney, EU Securities and Financial Markets Regulation, 443. Cf. Mutschler, Internalisierung der Auftragsausfuehrung im Wertpapierhandel (Internalization of Order Execution in Securities Trading), 297 et seqq.  EU Commission, 2011 MiFID II/MiFIR Proposals Impact Assessment, SEC (2011) 1226 (Oct. 20, 2011), 5; Moloney, EU Securities and Financial Markets Regulation, 437. Cf. Di Febo/Angelini, 26 Curr. Pol. & Econ. Eur. (2015), 267, 286.  Gresse, Effects of Lit and Dark Market Fragmentation on Liquidity (Mar. 2016), 14; cf. Moloney, EU Securities and Financial Markets Regulation, 443 – 444.  Cf. EU Commission, 2011 MiFID II/MiFIR Proposals Impact Assessment, SEC (2011) 1226 (Oct. 20, 2011), 12; Young/Pettifer/Fournier, 28 IFLR (2010), 25, 25; Moloney, EU Securities and Financial Markets Regulation, 442.

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on an OTC basis not further differentiated and specified under MiFID I.⁴²² As a result, the overall amount of dark trading increased, in particular dark pools which became very successful and popular, and by the wake of the financial crisis a significant amount of trades took place outside of organized trading venues and thus, outside of regulatory oversight.⁴²³ This also generated supervisory risks as the competent authorities were not able to monitor market abuse and other misconduct threatening financial stability.⁴²⁴ After the financial crisis in 2008 it became apparent that the reality of OTC trading in the EU market contradicted the regulatory intentions and that MiFID I had not succeeded in safeguarding market integrity and investor protection.⁴²⁵ The crisis also exposed shortcomings in the operation and transparency of the trading venues.⁴²⁶ Consequently, these events mainly influenced the negotiations during the MiFID I review which eventually revealed that a more robust regulatory framework was necessary.⁴²⁷

II. MiFID II and MiFIR The EU Commission concluded that overall, MiFID I had led to various improvements and that its underlying principles were valid although certain weaknesses had emerged.⁴²⁸ In particular, market fragmentation had created complexity and opaqueness within the trading environment and technical developments had

 Cf. Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.02.  Bernard, MiFID II: The new market structure paradigm (Feb. 2014), 2; cf. Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 2– 3.  Cf. Moloney, EU Securities and Financial Markets Regulation, 437.  Cf. EU Commission, 2011 MiFID II/MiFIR Proposals Impact Assessment, SEC (2011) 1226 (Oct. 20, 2011), 4– 5; Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.02, 14.36.  EU Commission, 2011 MiFID II/MiFIR Proposals Impact Assessment, SEC (2011) 1226 (Oct. 20, 2011), 4; Busch/Ferrarini, Who’s Afraid of MiFID II?: An Introduction, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 1.01– 1.57, 1.07.  EU Commission, Investment services and regulated markets – Markets in financial instruments directive (MiFID), https://ec.europa.eu/info/business-economy-euro/banking-and-finance/ financial-markets/securities-markets/investment-services-and-regulated-markets-markets-finan cial-instruments-directive-mifid_en (last visited Sept. 25, 2018); cf. Busch/Ferrarini, Who’s Afraid of MiFID II?: An Introduction, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 1.01– 1.57, 1.02, 1.07.  EU Commission, 2011 MiFID II/MiFIR Proposals Impact Assessment, SEC (2011) 1226 (Oct. 20, 2011), 5 – 6; cf. Moloney, EU Securities and Financial Markets Regulation, 446.

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outpaced the classification regime with the result that the market no longer represented a transparent level playing field between the trading venues and investment firms.⁴²⁹ Thus, the approach to reform the MiFID I regime was to correct those weaknesses instead of overhauling the whole regulatory framework. In addition, regulators worldwide were forced to find regulatory responses to the harmful effects of the financial crisis of 2007– 2009 and further solutions to protect the securities markets and market participants. The EU reforms therefore focus on traditional objectives including market efficiency, transparency, integrity and investor protection and aim at widening the regulatory net.⁴³⁰ The MiFID I review and the negotiations for a reform started soon after the enactment of MiFID I and 10 years later, in 2014, the EU regulator adopted a second Directive on Markets in Financial Instruments (MiFID II), accompanied by the correlative Markets in Financial Instruments Regulation (MiFIR) and a number of implementing measures by ESMA.⁴³¹ The next part first provides an overview of the legislative process, the regulatory concept, the timeframe and the transposition of the new regime into the national laws (1.), second it assesses the role of ESMA particularly within the new framework (2.), and third it outlines in greater detail the changes to MiFID I and new provisions related to dark trading (3.), before summarizing the critique and drawing a conclusion (4.).

1. Overview of Legislative Process, Regulatory Concept, Timeframe and Transposition into National Laws The financial crisis of 2007– 2009 triggered reforms with regarding not only the level of market regulation but also the level of the law-making process. Confronted with the difficulties due to the absence of a single rule book, in particular the lack of cohesiveness in the regulatory framework and the risk of regulatory arbitrage and inefficiencies, the EU Commission consented to a “more Europe” approach to reshape the foundational legislative process.⁴³² In 2011, the original

 EU Commission, 2011 MiFID II/MiFIR Proposals Impact Assessment, SEC (2011) 1226 (Oct. 20, 2011), 5, 10 – 11; cf. Moloney, EU Securities and Financial Markets Regulation, 446.  Moloney, EU Securities and Financial Markets Regulation, 35.  Directive 2014/65/EU of 15 May 2014 on markets in financial instruments (MiFID II) and Regulation (EU) No 600/2014 of 15 May 2014 on markets in financial instruments (MiFIR). See also Busch/Ferrarini, Who’s Afraid of MiFID II?: An Introduction, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 1.01– 1.57, 1.02 note 3.  Moloney, EU Securities and Financial Markets Regulation, 880 – 881.

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Lamfalussy Process was modified due to the enactment of the Treaty of Lisbon on December 1, 2009 and the establishment of ESMA.⁴³³ The reform strengthened ESMA’s quasi-rule-making powers and enhanced ESMA’s operational supervisory powers, however, it also significantly restricted the autonomy of the Member States. Although the legislative process is aimed at speeding up the adoption of the new measures, the implementation of the MiFID II/MiFIR regime proved to be a difficult undertaking and was delayed a few times. The new rules are applicable as of January 3, 2018. A brief overview of the legislative process, the regulatory concept, the timeframe and the transposition of the new regime into the national laws is given in the following.

a. Legislative Process The MiFID II/MiFIR regime was based on the revised Lamfalussy procedure, also referred to as Lamfalussy II Process. The main aspects about this procedure is that it comprises four levels.⁴³⁴ On Level 1 the EU Commission implements the “Framework Acts”, i. e. directives and regulations, that contain basic principles that ought to be further specified by Level 2 acts and Level 3 acts. On Level 2 ESMA is responsible to design “Delegated Acts” (Article 290 of the Treaty on the Functioning of the European Union (TFEU)) and “Implementing Measures” (Article 291 TFEU) regarding the Level 1 acts. The Commission can enact these Level 2 acts without having to adhere to the usual legislative procedure.⁴³⁵ The delegated acts on Level 2 are divided into “technical advice” delivered by ESMA upon request of the EU Commission and “regulatory technical standards” (RTS), delegated acts drafted by ESMA pursuant to Article 10 of EU Regulation No. 1095/2010 of November 24, 2010 (ESMA Regulation) which have to be endorsed by the EU Commission to become effective.⁴³⁶ The imple-

 Walla, Process and Strategies of Capital Markets Regulation in Europe, in: Veil, European Capital Markets Law, 39, 44. For more details on the EU law-making process and its development see Moloney, EU Securities and Financial Markets Regulation, 854 et seqq.  Busch/Ferrarini, Who’s Afraid of MiFID II?: An Introduction, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 1.01– 1.57, 1.02 note 3. See for more details Walla, Process and Strategies of Capital Markets Regulation in Europe, in: Veil, European Capital Markets Law, 39, 43 – 51.  Walla, Process and Strategies of Capital Markets Regulation in Europe, in: Veil, European Capital Markets Law, 39, 46.  Further details are provided below in section C.II.2.a. Walla, Process and Strategies of Capital Markets Regulation in Europe, in: Veil, European Capital Markets Law, 39, 46 – 47; cf. Busch/

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menting measures can also be divided into “implementing acts” and “implementing technical standards” (ITS) which also have to be endorsed by the EU Commission.⁴³⁷ As will be pointed out below the MiFID II/MiFIR regime relies heavily on delegated acts under Article 290 TFEU.⁴³⁸ On Level 3 ESMA has the power to issue “Guidelines” and “Recommendations” which are intended to provide standards for a consistent interpretation of the regulations and direct them to the national supervisory authorities or to market participants. Although these guidelines and recommendations are classified as soft law and thus, in contrast to Level 2 acts, are not legally binding, they are usually complied with since the Member States have to confirm their compliance or otherwise, if they refuse, have to file a reasoning for non-compliance.⁴³⁹ Finally, on Level 4, both the EU Commission and ESMA have the power to supervise and enforce EU regulations to ensure consistent application of the rules and Member States have to report on the progress if implementation to facilitate the supervision.⁴⁴⁰

b. Regulatory Concept The reform negotiations were guided by a number of objectives, including (1) the focus on principles set forth by the G20-Committee⁴⁴¹ and IOSCO⁴⁴², (2) more in-

Ferrarini, Who’s Afraid of MiFID II?: An Introduction, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 1.01– 1.57, 1.02 note 3.  Walla, Process and Strategies of Capital Markets Regulation in Europe, in: Veil, European Capital Markets Law, 39, 47; cf. Busch/Ferrarini, Who’s Afraid of MiFID II?: An Introduction, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 1.01– 1.57, 1.02 note 3.  Moloney, EU Securities and Financial Markets Regulation, 904.  Walla, Process and Strategies of Capital Markets Regulation in Europe, in: Veil, European Capital Markets Law, 39, 49; Veil, Sources of Law and Principles of Interpretation, in: Veil, European Capital Markets Law, 65, 81; cf. Busch/Ferrarini, Who’s Afraid of MiFID II?: An Introduction, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 1.01– 1.57, 1.02. See also Art. 17, 29 ESMA Regulation.  Walla, Process and Strategies of Capital Markets Regulation in Europe, in: Veil, European Capital Markets Law, 39, 50; cf. Busch/Ferrarini, Who’s Afraid of MiFID II?: An Introduction, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 1.01– 1.57, 1.02 note 3.  See e. g. G20, Leaders’ Statement: The Pittsburgh Summit (Sept. 24– 25, 2009), http://ec. europa.eu/archives/commission_2010 – 2014/president/pdf/statement_20090826_en_2.pdf (last visited Sept. 25, 2018). The G20-Committee agreed in particular to strengthen transparency and oversight of less regulated markets and to avoid market fragmentation and regulatory arbitrage.  IOSCO, Objectives and Principles of Securities Regulation (Feb. 2008); IOSCO Technical Committee, Principles for Dark Liquidity (May 2011).

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tegration by means of harmonization, (3) extended supervision and improved oversight and transparency, (4) maintenance and assurance of fair competition and efficient markets, (5) reduction of discretionary power of the Member States by creating more uniform framework.⁴⁴³ As previously stated, the European Commission (EU Commission, EU legislator) aimed at maximum harmonization and a more prescriptive and regulatory approach. Although the new rulebook is based on MiFID I continuing the ‘trading venue’ concept, it is significantly wider and deeper and, in particular, the scope of application of MiFID II is far more extended compared to its predecessor.⁴⁴⁴ To achieve maximum harmonization, the allocation of regulatory coverage across MiFID II and MiFIR is designed to cover that areas by the directive where implementational discretion is necessary to adjust the provisions to any existing specifications of the particular market and legal system in each Member State and to cover those areas by the regulation where uniformity is essential to market efficiency and investor protection.⁴⁴⁵ Hence, the structure of the new regulatory framework is basically as follows: “MiFID II broadly covers the authorization, organizational, and operational requirements which apply to trading venues” and “MiFIR broadly covers the transparency regime and transaction reporting, prescribes particular venues for share trading, and establishes the different venue classifications”.⁴⁴⁶ Given the great technical complexity of many of the new rules, their untested nature, and the lack of empirical evidence, the effectiveness of the new regime will largely depend on the quality of ESMA’s Level 2 acts.⁴⁴⁷ Given the ambiguity and complexity of the rules, market participants will further have to rely on ESMA’s guidelines and recommendations. Thus, a huge burden lies on ESMA. The material content of the MiFID II/MiFIR regime was made in view of the shortcomings of MiFID I exposed during the financial crisis of 2007– 2009 and in

 EU Commission, 2011 MiFID II/MiFIR Proposals Impact Assessment, SEC (2011) 1226 (Oct. 20, 2011), 20 et seqq. See also Gomber/Nassauer, 4 ZBB (2014), 250, 252– 253.  Cf. Moloney, EU Securities and Financial Markets Regulation, 517, 460; Pfisterer, Die neuen Regelungen der MiFID II zum Anlegerschutz (The new provisions of MiFID II on investor protection), 11.  Cf. Rec. 7 MiFID II; Moloney, EU Securities and Financial Markets Regulation, 459.  Moloney, EU Securities and Financial Markets Regulation, 458.  Moloney, EU Securities and Financial Markets Regulation, 459; Moloney, EU Financial Governance and Transparency Regulation: A Test for the Effectiveness of Post-Crisis Administrative Governance, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 12.01– 12.57, 12.02.

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response to the G20 commitment. Thus, it is intended to create a level playing field, improve transparency, and strengthen investor protection.⁴⁴⁸ The new regulatory framework covers broadly three main subjects related to dark trading. First, it intends to tackle the unregulated OTC sector and bring all organized trading venues within the regulatory net, thereby moving more trading to regulated trading venues and limiting the amount of OTC trading.⁴⁴⁹ By using the ‘trading venue’ concept, the MiFID II/MiFIR regime, therefore, widens the scope of trading venue classification.⁴⁵⁰ Second, it seeks to improve organization, transparency and oversight of trading venues and to expand the requirements to apply not only to equity instruments but also to non-equity instruments.⁴⁵¹ In particular, the requirements are designed to provide more transparency in the OTC sector and facilitate the distribution and consolidation of trading data. Third, it governs trading practices, in particular algorithmic trading and high-frequency trading, that had not been explicitly addressed by the regulations up to then. Although the new rules do not restrict HFT per se, they impose burdensome requirements and high costs on those traders engaging in HFT practices. Overall, the negotiations by the EU Commission, the EU Council and the EU Parliament proved to be long and difficult and tensions arose in particular with regard to three major points: (1) the new ‘organized trading facility’ (OTF) category and the extent to which it should be limited or not to non-equity asset classes, (2) the balance between dark and lit trading, particularly with respect to the transparency waiver regimes and the different calibrations sought by the Council, and (3) the extent to which detailed organizational regulation, orientated to algorithmic trading in particular, should be imposed on trading venues.⁴⁵²

 O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 119 – 120; EU Commission, Investment services and regulated markets – Markets in financial instruments directive (MiFID), https://ec.europa. eu/info/business-economy-euro/banking-and-finance/financial-markets/securities-markets/in vestment-services-and-regulated-markets-markets-financial-instruments-directive-mifid_en (last visited Sept. 25, 2018).  Cf. EU Commission, 2011 MiFID II/MiFIR Proposals Impact Assessment, SEC (2011) 1226 (Oct. 20, 2011), 61; Moloney, EU Securities and Financial Markets Regulation, 433, 446.  Cf. Moloney, EU Securities and Financial Markets Regulation, 460.  Moloney, EU Securities and Financial Markets Regulation, 433, 446, 461.  Moloney, EU Securities and Financial Markets Regulation, 457– 458.

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c. Timeframe The first proposals for the MiFID II/MiFIR regime by the EU Commission were published in October 2011⁴⁵³ but the negotiations particularly in respect of the trading venue regulation and the extent to which the MiFID I regime should be extended proved to be very long and difficult.⁴⁵⁴ In the end, the European Parliament’s negotiating position of October 2012 considerably deviated from the EU Commissions’ proposals.⁴⁵⁵ The EU Council took even longer until June 2013 to finalize its negotiations. The following “trilogue negotiations” finally led to the compromise reflected in the complex and detailed 2014 MiFID II/MiFIR regime. Initially the new regulations were supposed to apply in the Member States as of January 3, 2017.⁴⁵⁶ However, in May 2016 this deadline was extended and the rules did not take effect until January 3, 2018.⁴⁵⁷ The implementation of the double volume caps introduced in MiFIR was even delayed until March 2018 due to data quality and completeness issues.⁴⁵⁸

d. Transposition of MiFID II/MiFIR into National Laws As previously pointed out, MiFIR as a European regulation is self-executing and applies directly, while MiFID II as a European directive has to be transposed by

 EU Commission, COM (2011) 656/4 (2011 MiFID II Proposal) (Oct. 20, 2011); EU Commission, COM (2011) 652/4 (2011 MiFIR Proposal) (Oct. 20, 2011).  Cf. Moloney, EU Securities and Financial Markets Regulation, 455.  See the Parliament’s Resolution on the MiFID II Proposal EU Parliament, P7_TA(2012)0406 (2012 Parliament MiFID II Negotiating Position) (Oct. 26, 2012), and the Resolution on the MiFIR Proposal EU Parliament, P7_TA_PROV(2012)0407 (2012 Parliament MiFIR Negotiating Position) (Oct. 26, 2012).  Cf. Busch/Ferrarini, Who’s Afraid of MiFID II?: An Introduction, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 1.01– 1.57, 1.02 note 2.  The EU Council approved the EU Parliament’s agreement on a one-year delay to new securities market rules. See EU Council, Press Release 255/16, Markets in financial instruments: Council confirms agreement on one-year delay (May 18, 2016), http://www.consilium.europa.eu/en/ press/press-releases/2016/05/18/markets-financial-instruments/ (last visited Sept. 25, 2018). See also EU Parliament and EU Council, PE-CONS 23/16 – 2016/0033 (COD), draft directive amending MIFID II as regards certain dates (June 9, 2016), http://data.consilium.europa.eu/doc/document/ PE-23 – 2016-INIT/en/pdf (last visited Sept. 25, 2018) and EU Parliament and EU Council, PECONS 24/16 – 2016/0034 (COD), draft regulation amending MIFIR as regards certain dates (June 9, 2016), http://data.consilium.europa.eu/doc/document/PE-24– 2016-INIT/en/pdf (last visited Sept. 25, 2018).  ESMA, Press Release, ESMA delays publication of double volume cap data (Jan. 9, 2018), https://www.esma.europa.eu/sites/default/files/library/esma71-99 - 925_esma_dvc_delay.pdf (last visited Sept. 25, 2018).

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the Member States into their national laws.⁴⁵⁹ In regard to the procedural form of transposition the Member States have a wide margin of appreciation depending on the level of harmonization.⁴⁶⁰ A detailed discussion and assessment of the transposition process of European directives into national law would exceed the scope of this study. The following section will therefore only provide a brief overview of the main aspects as relevant to the underlying topic. Traditionally, there are two main concepts. Accordingly, the implementation can be done either one-to-one or also called ‘copy-out’ (often done by France, UK and Spain), which eliminates the danger of the national provisions violating EU law and achieves a high level of harmonization.⁴⁶¹ Other Member States (for instance Germany) traditionally deviate from the exact wording and adapt the provisions to the particularities of their national law.⁴⁶² While the ‘copy-out’ procedure prevents difficulties in interpretation, the adaption of the provisions requires further interpretation relying on legislative materials to achieve conformity with EU law.⁴⁶³ The scope of this margin of appreciation depends on the level of harmonization. In the case of minimum harmonization Member States are permitted to enact further autonomous national rules accompanying and exceeding the EU provisions, a procedure called ‘gold-plating’.⁴⁶⁴ However, as stated previously, the MiFID II/MiFIR regime aims at maximum harmonization, particularly in regard to the regulation of trading venues and trading practices that are subject to the following analysis. Thus, there is no room for gold-plating and the national provisions are largely conform with those agreed upon at the EU level. In order to avoid unnecessary repetition, the following section analyzes only the EU provisions under MiFID II/MiFIR and refers to national provisions of the Member States where they deviate.

 See also Walla, Process and Strategies of Capital Markets Regulation in Europe, in: Veil, European Capital Markets Law, 39, 57; Veil, Sources of Law and Principles of Interpretation, in: Veil, European Capital Markets Law, 65, 65, 80.  Walla, Process and Strategies of Capital Markets Regulation in Europe, in: Veil, European Capital Markets Law, 39, 57.  Walla, Process and Strategies of Capital Markets Regulation in Europe, in: Veil, European Capital Markets Law, 39, 58.  Walla, Process and Strategies of Capital Markets Regulation in Europe, in: Veil, European Capital Markets Law, 39, 58.  Walla, Process and Strategies of Capital Markets Regulation in Europe, in: Veil, European Capital Markets Law, 39, 58.  Walla, Process and Strategies of Capital Markets Regulation in Europe, in: Veil, European Capital Markets Law, 39, 58.

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2. The Role of ESMA Since January 1, 2011 the European Securities and Markets Authority (ESMA), established in 2010 as the successor of the former CESR, plays a key role in the legislative process.⁴⁶⁵ Although the main supervision of the securities markets still lies with the national supervisory authorities of each member state, ESMA’s impact continues to grow. ESMA’s regulatory power is conferred by the EU Regulation No. 1095/2010 of November 24, 2010 (ESMA Regulation) which also sets forth its responsibilities and the scope of operation.⁴⁶⁶ Accordingly, ESMA’s main task is to improve the functioning of the EU market by ensuring a high, effective and consistent level of regulation and supervision taking into account the varying interests of the Member States and the differences among the financial market participants.⁴⁶⁷ Further, it shall prevent regulatory arbitrage, guarantee a level playing field and strengthen international supervisory coordination to contribute to the achievement of the primary goals of securities markets regulation and investor protection.⁴⁶⁸ Due to the reform of the legislative process, ESMA gained excessive advisory function and quasi-rule-making power. In particular, ESMA is empowered to develop draft regulatory technical standards (RTS) and draft implementing technical standards (ITS), issue guidelines and recommendations, give technical advice and provide a centrally accessible database of registered market participants.⁴⁶⁹ Despite the quasi-rule-making power ESMA is also conferred some extent of supervisory power that previously was placed completely in the hands of the national supervisory authorities of the Member States.⁴⁷⁰ However, in contrast to the US where all supervisory power is centralized within one single institution, the SEC, the EU does not yet have a central supervisory institution.⁴⁷¹

 ESMA was established according to Art. 1 of the EU Regulation No 1095/2010 (November 24, 2010) (ESMA Regulation); see also Veil, History, in: Veil, European Capital Markets Law, 3, 16. For a general overview of ESMA’s role and more details regarding its operation see Walla, Capital Markets Supervision in Europe, in: Veil, European Capital Markets Law, 133, 153 et seqq. and Moloney, EU Securities and Financial Markets Regulation, 907 et seqq.  In particular Art. 1, 8 et seqq. ESMA Regulation.  Rec. 11 and Art. 8(1) ESMA Regulation.  Rec. 11 and Art. 8(1) ESMA Regulation.  Art. 8(2) ESMA Regulation.  See Rec. 40, 41 and Art. 29, 30 ESMA Regulation.  Walla, Capital Markets Supervision in Europe, in: Veil, European Capital Markets Law, 133, 149.

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a. Level 2 – Technical Advice and Binding Technical Standards Part of ESMA’s quasi-regulatory power is the technical advice ESMA provides, upon authorization by Level 1 legislation, to the EU Commission and to be included in legislative acts on Level 2 of the Lamfalussy II process.⁴⁷² In regard to the MiFID II/MiFIR regime the EU Commission mandated ESMA to provide technical advice for assistance on the possible content of the delegated acts which was delivered on December 19, 2014.⁴⁷³ ESMA may also be empowered by Level 1 legislation to develop draft binding technical standards (BTS) that comprise regulatory technical standards (RTS) and implementing technical standards (ITS) as set forth in Articles 290 and 291 TFEU and Articles 10 and 15 of the ESMA Regulation.⁴⁷⁴ Regulatory technical standards are delegated acts pursuant to Article 290 TFEU and require a legal foundation in a Level 1 act as well as confirmation by the EU Commission to become legally binding.⁴⁷⁵ RTS usually provide procedural rules.⁴⁷⁶ Implementing technical standards, on the other hand, are legislative acts pursuant to Article 291 TFEU and require endorsement by the EU Commission. Generally, ITS are supposed to determine the conditions of application of the legislative acts.⁴⁷⁷ Both, RTS and ITS are adopted by means of regulation or directly binding decisions and hence, constitute binding rules.⁴⁷⁸ The MiFID II/MiFIR regime relies heavily on BTS delegations, particularly in regard to the highly technical trading venue regulations set forth in MiFIR.⁴⁷⁹ ESMA is delegated the power to specify, for instance, the information that ought to be made public and the requirements of the transparency waivers.⁴⁸⁰  Moloney, EU Securities and Financial Markets Regulation, 920; Walla, Capital Markets Supervision in Europe, in: Veil, European Capital Markets Law, 133, 160. See also Art. 8(1)(a) ESMA Regulation.  ESMA, Final Report, ESMA’s Technical Advice to the Commission on MiFID II and MiFIR (Dec. 19, 2014).  Cf. Busch/Ferrarini, Who’s Afraid of MiFID II?: An Introduction, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 1.01– 1.57, 1.02 note 3; Moloney, EU Securities and Financial Markets Regulation, 921. See also Rec. 21, 25 and Art. 8(2) ESMA Regulation.  Walla, Capital Markets Supervision in Europe, in: Veil, European Capital Markets Law, 133, 162.  Cf. Walla, Capital Markets Supervision in Europe, in: Veil, European Capital Markets Law, 133, 163.  Walla, Capital Markets Supervision in Europe, in: Veil, European Capital Markets Law, 133, 163; cf. Art. 15 ESMA Regulation.  Art. 10(4), 15(4) ESMA Regulation. See Walla, Capital Markets Supervision in Europe, in: Veil, European Capital Markets Law, 133, 162.  Moloney, EU Securities and Financial Markets Regulation, 924.  Details and further information on the respective BTS are provided below in section C.II.3.

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Further, Article 5(9) of MiFIR requires ESMA to draft RTS detailing the method for gathering and publishing the data required for calculating total trading volumes and market shares of trades executed under certain pre-trade transparency waivers.⁴⁸¹ The draft RTS and ITS delivered by ESMA were included into Annex I of MiFID II/MiFIR.

b. Level 3 – Guidelines and Recommendations The new regulatory framework is further complemented by non-binding soft law measures which are “hardened” through “comply or explain” mechanisms.⁴⁸² Pursuant to Article 16 ESMA Regulation ESMA is empowered to issue guidelines and recommendations that are constituted as non-binding soft law.⁴⁸³ These guidelines and recommendation provide abstract and general requirements for market participants and the national supervisory authorities on how to interpret the law in order to ensure that the law is uniformly applied across the EU and to promote greater convergence across the national supervisory authorities.⁴⁸⁴ Article 16(4) ESMA Regulation requires national supervisory authorities to make every effort to comply with those guidelines and recommendations. Although they are not legally binding, in practice, the national supervisory authorities will be reluctant to disregard or deviant from the guidelines and recommendations.⁴⁸⁵ This is primarily a consequence of the novel “comply or explain” mechanism: In case the national supervisory authorities do not comply with the issued guidelines and recommendations, they must inform ESMA and file a statement pointing out the reasons for the non-compliance which shall then be published by ESMA.⁴⁸⁶ Thus, the effort and expenses to meet the obligation of “explaining” are high enough, that in practice the national supervisory authorities will likely rather comply with the guidelines than to bear that burden. Hence, the guidelines and recommendations are de facto binding or “hardened soft law”.

 Cf. Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.86.  Moloney, EU Securities and Financial Markets Regulation, 40.  See also Rec. 26 ESMA Regulation.  Walla, Capital Markets Supervision in Europe, in: Veil, European Capital Markets Law, 133, 161; Moloney, EU Securities and Financial Markets Regulation, 932.  Veil, Sources of Law and Principles of Interpretation, in: Veil, European Capital Markets Law, 65, 81; Moloney, EU Securities and Financial Markets Regulation, 930.  Cf. Rec. 26 and Art. 16(3) ESMA Regulation. See also Moloney, EU Securities and Financial Markets Regulation, 930.

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Under the MiFID II/MiFIR regime ESMA’s guidelines play a significant role, particularly in regard to the regulation of trading practices and HFT strategies.⁴⁸⁷ ESMA issued guidelines that aim to ensure that RMs and MTFs police and monitor their systems to identify market abuse and to minimize any potential disruption, and that investment firms engaging in algorithmic trading provide policies and procedures to minimize the risk that their trading activity gives rise to market abuse and to ensure the compliance with the rules of the relevant trading venue.⁴⁸⁸

c. Level 4 – Supervisory and Enforcement Power Generally, the supervision of the securities markets and in particular of trading venues remains with the national competent authorities of the Member States.⁴⁸⁹ ESMA does not have direct powers to intervene on the national level but it coordinates the national authorities and supervises their activities, thereby indirectly enhancing their compliance with EU law.⁴⁹⁰ According to Article 29 ESMA Regulation, ESMA is explicitly mandated to unify the supervisory activities in the EU and therefore, is empowered to adopt supervisory convergence measures, including opinions and principles provided to the national supervisory authorities and market participants, and ‘Q&As’ and ‘FAQs’.⁴⁹¹ Those measures have quasi-regulatory effects and are intended to have some degree of “quasi-binding quality”.⁴⁹² Besides, ESMA’s Board of Supervisors is composed of, among others,

 Since the regulation of trading practices is only indirectly related to dark trading, a thorough analysis of ESMA’s Guidelines and their regulatory impact on trading practices would go beyond the scope of this study. Thus, only a brief overview summarizing the main aspects is provided hereafter.  McVea, Supporting Market Integrity, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 631, 645; Conac, Algorithmic Trading and High-Frequency Trading (HFT), in: Busch/Ferrarini, Regulation of the EU Financial Markets, 17.01– 17.62, 17.30.  Cf. Walla, Capital Markets Supervision in Europe, in: Veil, European Capital Markets Law, 133, 135; Moloney, EU Securities and Financial Markets Regulation, 965 – 966.  Cf. Art. 1(5)(c), 31, 35 ESMA Regulation. See also Moloney, EU Securities and Financial Markets Regulation, 974; Walla, Capital Markets Supervision in Europe, in: Veil, European Capital Markets Law, 133, 155. However, one exception applies where ESMA is empowered to direct supervision of market participants: Under Art. 40 – 42 MiFIR ESMA has the right to prohibit the distribution, marketing or sale of certain financial products or financial services. See also Walla, Capital Markets Supervision in Europe, in: Veil, European Capital Markets Law, 133, 159.  See also Walla, Capital Markets Supervision in Europe, in: Veil, European Capital Markets Law, 133, 160.  Moloney, EU Securities and Financial Markets Regulation, 935 – 936; cf. Walla, Capital Markets Supervision in Europe, in: Veil, European Capital Markets Law, 133, 160.

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the heads of the national competent authorities.⁴⁹³ Another effective and efficient tool for assessing and comparing the supervisory activities of the national authorities are peer reviews pursuant to Article 30 ESMA Regulation.⁴⁹⁴ Further, Article 35 ESMA Regulation empowers ESMA to request information from the national authorities to perform its supervisory duties.⁴⁹⁵ Under certain circumstances ESMA may also intervene against national authorities and market participants by imposing individual decisions.⁴⁹⁶ With respect to the MiFID II/MiFIR regime, one of the key changes from MiFID I is the empowerment of ESMA to oversee national supervisory decision-making, particularly in regard to pre-trade transparency waivers and liquidity-based exemptions.⁴⁹⁷ Although national authorities still have full discretion and are not required to follow ESMA’s opinions on a proposed waiver or suspension, in contrast to MiFID I, they are formally required to notify ESMA about their decision and provide an explanation regarding the waiver.⁴⁹⁸ Within two months, ESMA must issue a non-binding opinion assessing the waiver’s compatibility with MiFIR.⁴⁹⁹ ESMA is also authorized to monitor the application of the waivers and must send annual reports to the EU Commission.

 Art. 40(1) ESMA Regulation.  See also Rec. 41 ESMA Regulation and Walla, Capital Markets Supervision in Europe, in: Veil, European Capital Markets Law, 133, 155; Moloney, EU Securities and Financial Markets Regulation, 990.  Walla, Capital Markets Supervision in Europe, in: Veil, European Capital Markets Law, 133, 155.  Rec. 29 and Art. 17– 19 ESMA Regulation. See for a detailed analysis Walla, Capital Markets Supervision in Europe, in: Veil, European Capital Markets Law, 133, 156 et seqq.; Moloney, EU Securities and Financial Markets Regulation, 976 et seqq.  See, for instance, Art. 4(4), (5) MiFIR in accordance with Art. 19 ESMA Regulation; Busch/ Ferrarini, Who’s Afraid of MiFID II?: An Introduction, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 1.01– 1.57, 1.32; Moloney, EU Financial Governance and Transparency Regulation: A Test for the Effectiveness of Post-Crisis Administrative Governance, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 12.01– 12.57, 12.36; Moloney, EU Securities and Financial Markets Regulation, 501. See below in section C.II.3.d.ii. for details on pre-trade transparency waivers and exemptions as provided in MiFID II/MiFIR.  Art. 4(4), (5) MiFIR in accordance with Art. 19 ESMA Regulation. See also Moloney, EU Financial Governance and Transparency Regulation: A Test for the Effectiveness of Post-Crisis Administrative Governance, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 12.01– 12.57, 12.40; Busch/Ferrarini, Who’s Afraid of MiFID II?: An Introduction, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 1.01– 1.57, 1.32.  Moloney, EU Financial Governance and Transparency Regulation: A Test for the Effectiveness of Post-Crisis Administrative Governance, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 12.01– 12.57, 12.36.

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Further, on February 7, 2018 ESMA published a Q&A pursuant to Article 29(2) of the ESMA Regulation governing a wide range of topics addressed in the new regulations, including transparency requirements, the waiver regime, the double volume cap mechanism and systematic internalization, and providing answers in respect to their practical application.⁵⁰⁰

3. Regulatory Changes and New Provisions under MiFID II/MiFIR In accordance with the shared principles to strengthen the financial system as agreed on by the G20 Leaders’ Statement in 2009⁵⁰¹ and set forth by the IOSCO in 2011,⁵⁰² the EU Commission points out that the new MiFID II/MiFIR regime is intended to improve regulation, functioning and transparency of the securities markets, and in particular, (1) to ensure that organized trading takes place on regulated trading venues and to reduce the OTC trading sector, and (2) to eliminate regulatory arbitrage that resulted from MiFID I.⁵⁰³ Addressing the concerns in regard to dark trading and taking into account the significant structural changes the securities markets have undergone since the implementation of MiFID I, the EU Commission imposed amendments to the existing provisions as well as a set of new rules, in particular: (1) changes to the classification of multilateral trading venues and the introduction of the new category ‘organized trading facilities’ (OTF) to minimize unregulated order execution, (2) changes to the regulation of bilateral trading venues, in particular systematic internalizers, (3) the introduction of a trading obligation for equity instruments, (4) the enhanced transparency regime with changes in regard to transparency waivers, (5) the establishment of the double volume cap regime to limit the amount executed through dark pools, (6) the introduction of a regulatory framework governing the distribution and consolidation of trading data, and (7) the implementation of a harmonized regulatory regime governing algorithmic trading and HFT.

 ESMA, Questions and Answers on MiFID II and MiFIR transparency topics (Feb. 7, 2018), https://www.esma.europa.eu/system/files_force/library/esma70 - 872942901-35_qas_trans parency_issues.pdf (last visited Sept. 25, 2018).  G20, Leaders’ Statement: The Pittsburgh Summit (Sept. 24– 25, 2009), http://ec.europa.eu/ archives/commission_2010 – 2014/president/pdf/statement_20090826_en_2.pdf (last visited Sept. 25, 2018).  IOSCO Technical Committee, Principles for Dark Liquidity (May 2011).  Cf. Rec. 125 MiFID II, Rec. 25 MiFIR. See also Jacobs/Beker, Recasting of MiFID: Overview of the Provisions of the new Markets in Financial Instruments Directive and Regulation, BaFin (Aug. 15, 2014), https://www.bafin.de/dok/7874372 (last visited Sept. 25, 2018).

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a. Regulatory Changes to Classification of Multilateral Trading Venues and Introduction of Organized Trading Facilities As pointed out, one primary goal of the MiFID II/MiFIR regime is to reduce unregulated order execution and to ensure that all organized trading will take place either on regulated trading venues or through systematic internalization.⁵⁰⁴ Therefore, under the new regulatory framework, any multilateral system in financial instruments is categorized as a trading venue and subject to specific venue regulation.⁵⁰⁵ Pursuant to Article 4(1)(19) MiFID II a multilateral system is any system or facility in which multiple third party buying and selling trading interest in financial instruments are able to interact in the system. Further, the regulatory framework also covers investment firms, i. e. essentially bilateral venues, that in an organized, frequent, systematic and substantial basis, deal on own account on a bilateral basis. The venue classification system is still based on MiFID I and comprises RMs, MTFs and SIs. In addition to those already existing venue categories, the EU Commission introduced a new category, called ‘organized trading facility’ (OTF), to capture organized trading in non-equity instruments that, at that time, took place outside RMs, MFTs and SIs.⁵⁰⁶

i. Introduction of Organized Trading Facility The organized trading facility is defined in Art. 4(1)(23) MiFID II as a “multilateral system which is not a regulated market or an MTF and in which multiple third-party buying and selling interests in bonds, structured finance products, emission allowances or derivatives are able to interact in the system”.⁵⁰⁷ This category covers new trading platforms which do not meet the definition of an RM or MTF.⁵⁰⁸

 See Rec. 6 and 10 MiFIR; Gomber/Nassauer, 4 ZBB (2014), 250, 253; Moloney, EU Securities and Financial Markets Regulation, 461.  Financial Conduct Authority, TR16/5: UK equity market dark pools – Role, promotion and oversight in wholesale markets (July 2016), 50; Moloney, EU Securities and Financial Markets Regulation, 462.  Rec. 8 MiFIR; see also Rec. 9 MiFID II and Art. 4(1)(23) MiFID II.  The operation of an OTF was also added to the activities usually carried out by an investment firm as set forth in Art. 4(1), (2) MiFID II in relation to Annex I, Sec. A(9) MiFID II.  The OTF category is the European equivalent to the Swap Execution Facility introduced with the Dodd-Frank Act. A comparison of those two facilities is provided by Thelen, Dark Pools – Schattenbörsen im Lichte US-amerikanischer, europäischer und deutscher Kapitalmarktregulierung (Dark Pools – Dark Trading Platforms in the Light of US-American, European and German Capital Market Regulation), 149 et seqq.

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The introduction of OTFs was one of the most controversial topics of the negotiations during the MiFID I review. Divergences arose across the Member States, in particular between the UK, where the largest OTC trading market in the EU is located and which therefore opposes heavy restrictions on the OTC sector, and France, which mainly bears organized and lit trading venues and thus, was in favor with the proposed restrictions on the OTC sector.⁵⁰⁹ Despite the overarching question whether to introduce the OTF venue at all – which was later agreed on in the affirmative – the other controversially discussed issue was which financial instruments to cover. Initially, it was supposed to cover equity and non-equity instruments alike, but the coverage of these very different asset classes faced two major difficulties. First, trading of non-equity instruments requires discretion as those instruments are mainly illiquid and transactions are executed usually by proprietary trading or matched principal trading.⁵¹⁰ The discretionary element reflects this nature and protects the position of dealers.⁵¹¹ However, for equity instruments this discretion would lead to regulatory arbitrage, as OTFs would be treated differently than RMs or MTFs which are required to offer non-discretionary order execution and non-discretionary access, and cause poor quality of transparency data resulting in a harmful impact on price discovery.⁵¹² Second, in order to reduce the risks arising from discretion, the EU Commission attempted to prohibit proprietary trading within the OTF. However, such a prohibition would collide with long-established market practices in the nonequity sector and therefore, likely decrease OTF liquidity and prejudice investors.⁵¹³ The final solution was to limit the scope of OTFs to non-equity instruments and to allow the exercise of discretion in regard to venue access and order exe-

 Cf. Moloney, EU Securities and Financial Markets Regulation, 456.  Matched principal trading is defined in Art. 4(1)(38) MiFID II as a “transaction where the facilitator interposes between the buyer and the seller to the transaction in such a way that it is never exposed to market risk throughout the execution of the transaction, with both sides executed simultaneously, and where the transaction is concluded at a price where the facilitator makes no profit or loss, other than a previously disclosed commission, fee or charge for the transaction.” See also Bernard, MiFID II: The new market structure paradigm (Feb. 2014), 5.  Cf. Moloney, EU Securities and Financial Markets Regulation, 450, 464.  EU Parliament, P7_TA_PROV(2012)0407 (2012 Parliament MiFIR Negotiating Position) (Oct. 26, 2012), Rec. 16. See Rec. 7, 9 MiFIR; the different rules for RMs and MTFs are provided in Art. 19(1)(5) (MTF), Art. 47(1)(d) (RM) MiFID II.  Moloney, EU Securities and Financial Markets Regulation, 466.

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cution and permit matched principal trading and, under certain limited circumstances, proprietary trading within the OTF.⁵¹⁴ The main differences between OTFs and RMs/ MTFs are that OTFs are not available for equity trading but can only support trading in bonds, structured finance products, emission allowances, or derivates⁵¹⁵ and that the operator of an OTF may exercise discretion in two instances: (1) when deciding whether to place or retract an order on the OTF, and (2) when deciding whether to match a specific client order with other orders available in the system at a certain time.⁵¹⁶ By contrast, RMs and MTFs are required to apply non-discretionary rules for order execution.⁵¹⁷ Despite these instances where they can exercise discretion, OTFs are subject to the same rules which apply to MTFs and thus function as a subsidiary category to capture MTFs that trade non-equity instruments and offer discretion in order execution and venue access.⁵¹⁸ Article 20(7) MiFID II points out that the authorization of OTFs shall be restrictive to ensure that the venue operators do not circumvent the stricter requirements of MTFs.

ii. Alignment of Regulatory Requirements The second aim behind the changes to the venue classification system is to minimize regulatory arbitrage caused by MiFID I and to ensure that functionally similar trading is subject to similar rules.⁵¹⁹ The most evident issue was the different

 Rec. 9 MiFIR; Art. 20 MiFID II (specific requirements for OTFs). Proprietary trading is only permitted in regard to sovereign debt instruments for which there is not a liquid market, Art. 20(3) MiFID II. See also Moloney, EU Securities and Financial Markets Regulation, 455; Zickert, Regulierung des Hochfrequenzhandels in US- und EU-Aktienmaerkten (Regulation of Highfrequency Trading in US and EU equity markets), 74– 75.  Art. 4(1)(23) MiFID II; Rec. 8, 9 MiFIR; Moloney, EU Financial Governance and Transparency Regulation: A Test for the Effectiveness of Post-Crisis Administrative Governance, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 12.01– 12.57, 12.15; Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.60.  Art. 20(6) MiFID II; Gomber/Nassauer, 4 ZBB (2014), 250, 253; Moloney, EU Securities and Financial Markets Regulation, 465; Bernard, MiFID II: The new market structure paradigm (Feb. 2014), 4. It should be noted that both, order execution and limitations on the access to OTFs, must be non-discriminatory and in compliance with specific client instructions and best execution obligations.  Art. 19(1)(5) (MTF), Art. 47(1)(d) (RM) MiFID II.  See below in section C.II.3.a.iii.  See above in section C.I.2.; EU Commission, 2011 MiFID II/MiFIR Proposals Impact Assessment, SEC (2011) 1226 (Oct. 20, 2011), 10.

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regulation of RMs and MTFs that led to unequal treatment of those venues in areas where there were no actual differences that could justify a different regulation. Under MiFID I, RMs were subject to the highest level of regulation as they were also operating in the primary market and were subject to certain rules governing the admission of issuers and financial instruments. Thus, some of the different regulations were in fact a result from this distinct characteristic, although they were not entirely justifiable. For example, rules relating to admission to trading of financial instruments and the verification of issuer disclosure obligations applied only to RMs and, unlike MTFs, RMs could trade an issuer’s shares admitted to trading on another RM only eighteen months after the original admission and only after the publication of a summary note of the issuer’s prospectus.⁵²⁰ However, other differences, particularly in regard to organizational requirements, actually led to an unlevel playing field among RMs and MTFs. While RMs had to meet strict and comprehensive organizational requirements, MTFs operated by investment firms were subject to less stringent and much broader requirements. Pursuant to Article 39(a) to (c) MiFID I RMs are required, for example, to have arrangements to identify clearly and manage the potential adverse consequences of any conflict of interest, to implement appropriate arrangements and systems to identify all significant risks to its operation, and to have arrangements for the sound management of the technical operations of the system. In contrast, Article 13(4) MiFID I requires an investment firm to take reasonable steps to ensure continuity and regularity in the performance of investment services and activities, and to employ appropriate and proportionate systems, resources and procedures for this purpose. The test of “proportionality” offered a large scope of interpretation and discretion.⁵²¹ Hence, the new approach was to basically align the regulations either in respect of the functionality of a trading venue as multilateral (RMs, MTFs, OTFs) or bilateral (SI and other OTC venues), or in respect of the characterization as regulated market (the traditional RM) or investment service (MTFs, OTFs, SIs).⁵²² Acknowledging that RMs and MTFs have the same functionality, under the new regime the requirements of MTFs were aligned with those of RMs, a neces-

 CESR, Technical Advice to the Commission in the Context of the MiFID I Review – Equity Markets, Consultation Paper CESR/10 – 394 (Apr. 2010), 25 – 26.  CESR, Technical Advice to the Commission in the Context of the MiFID I Review – Equity Markets, Consultation Paper CESR/10 – 394 (Apr. 2010), 26.  Cf. Moloney, EU Securities and Financial Markets Regulation, 462. See the proposals made by CESR, Technical Advice to the Commission in the Context of the MiFID I Review – Equity Markets, Consultation Paper CESR/10 – 394 (Apr. 2010), 25 et seqq.

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sity in the endeauvour of creating a level playing field.⁵²³ For example, the organizational requirements for MTFs and OTFs, set forth in Articles 18 and 19 MiFID II, were extended in line with those for RMs and apply in addition to those of investment firms (Article 16 MiFID II). In turn, the requirements for OTFs are similar to those of MTFs in respect of their equal characterization as investment services, as laid down in Annex I, Section A(8) of MiFID II, with exceptions and specific calibrations in regard to their discretionary power, including businessconduct rules and provisions governing the exercise of discretion.⁵²⁴ The following paragraphs outline the most important requirements that specifically apply to RMs and MTFs/OTFs as multilateral trading venues to provide an overview of the similarities and differences.

iii. Requirements for RMs The operational requirements for RMs are broadly similar to the MiFID I regime. First, they must be authorized as RMs to operate as such. Pursuant to Article 44(1) MiFID II trading venues seeking classification as RMs will be granted authorization if they comply with the requirements for RMs set forth in Title III of MiFID II (Articles 44 et seqq. MiFID II) and can otherwise be refused or withdrawn (Articles 44(5), (6) and 45(7) MiFID II). The organizational requirements in Title III of MiFID II applying to RMs mainly cover provisions for risk management and the sound functioning of the venue, transparent and non-discretionary rules and procedures that support fair and orderly trading and efficient execution.⁵²⁵ Overall, the regime provides great flexibility for RMs to design their own trading and access rules.⁵²⁶ Further, operators of RMs are prohibited from executing client orders against proprietary capital and from engaging in matched principal trading.⁵²⁷ In response to the concern about the reduction of liquidity, the new regulations also provide for the protection of liquidity levels by introducing, for instance a trading halt regime in Article 48(4) and (5) MiFID II and market making requirements in Article 48(2) and (3) MiFID II.⁵²⁸ In this regard, ESMA’s role comes into effect as the rules in Article 48 MiFID II delegate further specifications to RTS.⁵²⁹ Moreover, RMs

      

Bernard, MiFID II: The new market structure paradigm (Feb. 2014), 3. See for example Art. 20(8) MiFID II. See for example Art. 47, 48 MiFID II. Moloney, EU Securities and Financial Markets Regulation, 469. Moloney, EU Securities and Financial Markets Regulation, 471. Art. 47(2) MiFID II; Moloney, EU Securities and Financial Markets Regulation, 472– 473. Art. 48(12) MiFID II; Moloney, EU Securities and Financial Markets Regulation, 473.

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must establish and maintain effective arrangements and procedures for the regular monitoring of compliance with their rules on the part of their members or participants (Article 54 MiFID II).

iv. Requirements for MTFs and OTFs MTFs and OTFs also require authorization and are subject to the general investment firm authorization process set forth in Article 5 MiFID II. The operators must submit a detailed description of the functioning of the MTF/OTF. Any authorization must be notified to ESMA which establishes a list of all MTFs and OTFs in EU (Article 18(10) MiFID II).⁵³⁰ The general organizational requirements are laid down in the Articles under Title II of MiFID II, in particular in Articles 16 and 18 MiFID II. Operators of MTFs/OTFs must establish transparent rules and procedures for fair and orderly trading and establish objective criteria for efficient execution of orders. In addition, they must comply with liquidity-supporting conditions provided in Article 18(7) MiFID II and are subject to market monitoring rules that replicate those which apply to RMs (Article 31 MiFID II).⁵³¹ Further, MTFs are subject to specific requirements in Article 19 MiFID II. Accordingly, they must implement non-discretionary rules for order execution and may not execute client orders against proprietary capital or engage in matched principal trading.⁵³² This provision reflects the similarities with RMs and thus, contains similar regulations. As pointed out previously, OTFs are characterized by two discretionary elements and thus, are not subject to Article 19 MiFID II.⁵³³ Parallel to the requirements applying to RMs under Article 47 MiFID II, operators of MTFs and OTFs are similarly required to be adequately equipped to manage risks and in particular conflicts of interests. According to Article 18(4) MiFID II, they must have arrangements to identify clearly and manage the potential adverse consequences for the operation of the MTF/OTF or for the members or participants and users, of any conflicts of interest between the interests of the MTF/OTF its owners or the investment firm or market operator operating the MTF/OTF and the sound functioning of the MTF/OTF. In addition, Article 18(5) MiFID II requires operators of MTFs/OTFs to comply with the regime under Articles 48 and 49 MiFID II. OTFs are further subject to specific calibrations in respect of their discretionary functionality. Article 20 MiFID II provides rules re-

   

Moloney, EU Securities and Financial Markets Regulation, 475 – 476. Moloney, EU Securities and Financial Markets Regulation, 477. Art. 19(1), (5) MiFID II. See above in section C.II.3.a.i.

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garding the exercise of the discretion, the extent to which OTFs can engage in proprietary trading and the application of business-conduct rules.⁵³⁴ In regard to the regulation of venue access, Article 53(1) MiFID II requires RMs to establish, implement, and maintain transparent and non-discriminatory rules, based on objective criteria, which govern the access to or membership of the RM. Restrictions are imposed on those who may be admitted to the venue.⁵³⁵ The requirements of MTFs and OTFs are laid down in Article 18(3) MiFID II. Reflecting the similar functionalities as multilateral trading venues, the provisions are aligned with those of RMs and therefore identical.

v. Conclusion Overall, the requirements for multilateral trading venues were aligned, according to their similar functionality, and also extended to cover not only equity and equity-like instruments, as it was the case under MiFID I, but also non-equity instruments. Thus, only very few cases will be exempt from the obligation to operate as one of the three types of trading venues.

b. Regulatory Changes for Systematic Internalizers The new regime also imposed regulatory changes for bilateral trading venues and specified the SI venue classification to address the issue of regulatory arbitrage associated with the SI definition of MiFID I that was primarily qualitative and lacked clarity regarding the criteria.⁵³⁶ Article 4(1)(20) MiFID II defines ‘systematic internalizer’ as “an investment firm which, on an organized, frequent, systematic and substantial basis, deals on own account when executing client orders outside a regulated market, an MTF or an OTF without operating a multilateral system.” In contrast to MiFID I, under the new regime SIs are explicitly not categorized as ‘trading venue’ pursuant to Article 4(1)(24) MiFID II. This clarifies their distinction from OTFs which may also, under certain circumstances, engage in proprietary trading and matched principal trading.⁵³⁷ Article 4(1)(2) MiFID II further clarifies that the characteristics ‘frequent’ and ‘systematic’ shall be measured by the number of OTC trades in the financial instrument carried out by the investment firm on own account when executing cli   

See also Moloney, EU Securities and Financial Markets Regulation, 479. Moloney, EU Securities and Financial Markets Regulation, 473. Moloney, EU Securities and Financial Markets Regulation, 467 note 263. See Art. 20 MiFID II.

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ent orders. The ‘substantial basis’ shall be determined based on the size of OTC trading either in relation to the total trading of the firm in a specific financial instrument or in relation to the total trading in the EU in a specific financial instrument.⁵³⁸ Hence, investment firms operate as SIs only in relation to particular financial instruments.⁵³⁹ Details for the determination of those requirements and the related thresholds for each financial instrument are laid down in Articles 12 to 16 of the EU Commission’s Delegated Regulation 2017/565 of April 25, 2016⁵⁴⁰. However, there are still issues that remain unsolved. For instance, it is not yet clear which type of transaction has to be taken into account to calculate the thresholds.⁵⁴¹ According to the EU legislator’s goal to increase transparency in the OTC market, the rules should apply, in any case, when an investment firm actually executes a transaction on the secondary market. This is, however, not further clarified. If SIs do not meet the requirements, i. e. if they do not reach or exceed the threshold that renders their activity ‘frequent’, ‘systematic’, and ‘substantial’, their operation falls within the OTC sector and thus, outside of the regulated venue categories. Consequently, they are subject only to general and trading-specific investment firm requirements, including requirements governing the authorization, organization and business-conduct.⁵⁴² The new quantitative criteria imply burdensome measurements and calculations to be taken by investment firms for each financial instrument they trade in, beginning of January 3, 2018.⁵⁴³ Despite the uncertainty that still remains in re-

 Art. 4(1)(20) MiFID II.  Moloney, EU Securities and Financial Markets Regulation, 467; cf. Seiffert/Lembke, Handelstransparenz (Trade Transparency), in: Ellenberger/Clouth, Praktikerhandbuch Wertpapier- und Derivategeschaeft (Textbook on Securities and Derivatives Business), 875 – 908, para. 2383 – 2384.  EU Commission Delegated Regulation 2017/565 of 25 April 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive, published in Official Journal of the European Union, L 87/1 (Mar. 31, 2017).  BaFin, Systematische Internalisierung: Eckpunkte des neuen Aufsichtsregimes (Systematic Internalization: Key points of the new supervisory regime) (Apr. 15, 2017), https://www.bafin. de/SharedDocs/Veroeffentlichungen/DE/Fachartikel/2017/fa_bj_1704_Internalisierung.html (last visited Sept. 25, 2018).  Moloney, EU Securities and Financial Markets Regulation, 467, 479.  Consequently, the relevant numbers and measures necessary for the first calculation covering the time period of January 3 until June 30, 2018 will be available for the first time on August 1, 2018. All concerned investment firms will have to make the calculations in respect of the threshold afterwards until September 1, 2018. See, for example, the explanations by the German national supervisory authority, BaFin, Systematische Internalisierung: Eckpunkte des neuen Aufsichtsregimes (Systematic Internalization: Key points of the new supervisory regime) (Apr. 15, 2017),

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spect of the new criteria, even though the EU Commission tried to provide further clarification in the Delegated Regulation 2017/565, the related measurements and calculations are likely to impose high additional costs for investment firms.⁵⁴⁴

c. Trading Obligation As pointed out, the new OTF category only applies to investment firms trading in non-equity instruments. With respect to the regulatory goal to ensure that trading takes place on regulated venues, this would be of only limited effect and cause regulatory arbitrage if equity and equity-like instruments could still be traded to a large extent in the OTC sector. MiFIR therefore also contains a new “trading obligation”, according to which investment firms are obliged to execute trades in shares on regulated venues or through SIs, if these shares are admitted to trading on an RM or traded on a trading venue.⁵⁴⁵ An exemption applies if “the trades are non-systematic, ad-hoc, irregular and infrequent, or are technical trades such as give-up trades which do not contribute to price discovery.”⁵⁴⁶ In Article 23 of RTS 1 in Annex I of MiFID II/MiFIR, ESMA sets forth the specific requirements under which a transaction is deemed a “transaction that does not contribute to price discovery”. The exemption applies, for example, to transactions that are executed by reference to a price that is calculated over multiple time instances according to a given benchmark, including transactions executed by reference to a volume-weighted average price or a time-weighted average price. It also comprises transactions that are contingent on the purchase, sale, creation or redemption of a derivative contract or other financial instrument where all the components of the trade are to be executed only as a single lot such as exchanges for related positions. These transactions can still be executed on the OTC basis. In Recital 11 of MiFIR the EU Commission points out that the exemptions from the trading obligation shall not be used to circumvent the restrictions introduced on the use of the reference price waiver and the negotiated price

https://www.bafin.de/SharedDocs/Veroeffentlichungen/DE/Fachartikel/2017/fa_bj_1704_In ternalisierung.html (last visited Sept. 25, 2018).  See examples by BaFin, Systematische Internalisierung: Eckpunkte des neuen Aufsichtsregimes (Systematic Internalization: Key points of the new supervisory regime) (Apr. 15, 2017), https://www.bafin.de/SharedDocs/Veroeffentlichungen/DE/Fachartikel/2017/fa_bj_1704_In ternalisierung.html (last visited Sept. 25, 2018).  Art. 23(1) MiFIR; Financial Conduct Authority, TR16/5: UK equity market dark pools – Role, promotion and oversight in wholesale markets (July 2016), 50.  Art. 23(1)(a) and (b) MiFIR; see also Rec. 11 MiFIR. Art. 28 MiFIR contains a similar provision that applies to trading in derivatives.

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waiver or to operate crossing systems. This stresses the underlying purpose, laid down in Recital 6 of MiFIR, to prevent trade execution on a client-to-client basis as it is done by broker crossing networks (the typical dark pools) and ensure that any investment firms performing internal matching are authorized as MTFs or SIs.⁵⁴⁷ The trading obligation will significantly affect trading venue decisions and the market share distribution between OTC trading, SIs, and multilateral trading venues.⁵⁴⁸ In fact, this will shift volumes from OTC trading into regulated venues and drastically reduce the current amount of dark trading.⁵⁴⁹ However, the trading obligation does not apply to non-equity instruments and therefore, does not equally restrict OTC trading in equities and non-equities.⁵⁵⁰

d. Enhanced Transparency Regime and Changes to Transparency Waivers Further significant changes are made in respect of the transparency regime. While MiFID I limited transparency requirements to equity instruments, the new regime extensively enhances the requirements to cover also non-equity instruments, thereby acknowledging that trading in either class of instruments is done in largely the same fashion and fulfils an almost identical economic purpose.⁵⁵¹ The EU Commission emphasizes the importance of maximum harmonization to achieve the overarching goal to strengthen transparency and establish a uniform regime by laying down the relevant provisions in MiFIR, which is directly applicable on a national level leaving no room for implementational discretion.⁵⁵² Moreover, ESMA plays an important role in the transparency regime as  Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.61; Güllner WM (2017), 938, 940 – 941.  Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.65.  Cf. Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.93.  Cf. Moloney, EU Securities and Financial Markets Regulation, 468. Apparently, this is the result of a compromise between the European Parliament’s prescriptive approach and Council’s liberal approach on how to restrict OTC trading and whether to cover all financial instruments.  Art. 3(1) and 8(1) MiFIR; Rec. 1 MiFIR. See also Moloney, EU Financial Governance and Transparency Regulation: A Test for the Effectiveness of Post-Crisis Administrative Governance, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 12.01– 12.57, 12.22; Busch/Ferrarini, Who’s Afraid of MiFID II?: An Introduction, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 1.01– 1.57, 1.30; Seiffert/Lembke, Handelstransparenz (Trade Transparency), in: Ellenberger/Clouth, Praktikerhandbuch Wertpapier- und Derivategeschaeft (Textbook on Securities and Derivatives Business), 875 – 908, para. 2395 – 2396.  See Rec. 12 MiFIR.

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it is charged with drafting administrative rules, primarily RTS, to further specify the requirements.

i. Pre-Trade Transparency Requirements Based on a grading concept, the transparency requirements are designed to apply in their most extensive form to the multilateral trading venues, i. e. RMs, MTFs and OTFs, and in a reduced form to bilateral trading.⁵⁵³ According to Articles 3(1) and 6(1) of MiFIR⁵⁵⁴, RMs, MTFs and OTFs are subject to identical pre- and post-trade transparency requirements that are based on the MiFID I concept. Thus, operators of RMs, MTFs and OTFs have to make public current bid and offer prices and the depth of trading interests at those prices which are advertised through their systems. Changes and extensions are made, however, in regard to the financial instruments that are covered by the transparency regime. Pursuant to Chapter 1 and Chapter 2 under Title II of MiFIR the regime applies to equity, equity-like and, in a major change from MiFID I, also to non-equity instruments.⁵⁵⁵ ESMA is delegated the power to specify the information that ought to be made public, i. e. the range of bid and offer prices and the depth of trading interest at those prices.⁵⁵⁶ The description of the type of trading systems and the related information to be made public in accordance with Article 3 MiFIR are set forth in Table 1 in Annex I of RTS 1. For example, continuous auction order book trading systems⁵⁵⁷ are required to make public the aggregate number of orders and the financial instruments they represent at each price level for at least the five best bid and offer price levels. Quote-driven trading systems⁵⁵⁸ have to publish the best bid and offer by price of each financial instru-

 Busch/Ferrarini, Who’s Afraid of MiFID II?: An Introduction, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 1.01– 1.57, 1.30. Cf. Art. 3, 6, 8, 10 MiFIR.  Applying to equity/equity-like instruments. See for non-equity instruments Art. 8(1) and 10 (1) MiFIR.  See Art. 3(1), 6(1) and 8(1), 10(1) MiFIR. Cf. Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.64.  Art. 4(6) MiFIR.  In Table 1, this type of trading system is described as “a system that by means of an order book and a trading algorithm operated without human intervention matches sell orders with buy orders on the basis of the best available price on a continuous basis.”  In Table 1, this type of trading system is described as “a system where transactions are concluded on the basis of firm quotes that are continuously made available to participants, which requires the market makers to maintain quotes in a size that balances the needs of members and participants to deal in a commercial size and the risk to which the market maker exposes itself.”

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ment traded on the trading system, together with the volumes attaching to those prices. Most notably, Article 3(1) of MiFIR⁵⁵⁹ also applies to actionable indications of interests (IOIs), i. e. the messages sent from a participant to another within the trading venue in relation to available trading interest that contains all necessary information to agree on a trade.⁵⁶⁰ This is of significant importance for dark trading as they allow participants to anonymously share their trading interest.⁵⁶¹ Consequently, venues are required to make IOIs publicly available unless they are subject to a transparency waiver. This will further limit anonymous trading and decrease informational asymmetries among market participants, thereby improving market efficiency and investor protection. In the bilateral sector, pre-trade transparency requirements apply only to SIs though with some restrictions.⁵⁶² Pursuant to Article 14(1) MiFIR the obligation to publish firm quotes for equity and equity-like instruments only applies to those financial instruments for which there is a liquid market. The liquidity requirement is intended to protect the trading position of SIs since they are at higher risk as they deal on their own account.⁵⁶³ A ‘liquid market’ for the purpose of Article 14 MiFIR is defined in Article 2(1)(17)(b) MiFIR as a market for a financial instrument that is traded daily, where the market is assessed according to (1) the free float, (2) the average daily number of transactions in those financial instruments, and (3) the average daily turnover for those financial instruments. If the market is not liquid, quotes are to be provided to clients only upon request.⁵⁶⁴ Pursuant to Article 14(2) and (3) MiFIR SIs are required to publish quotes only when they deal in sizes up to standard market size of the respective financial instrument and they may decide the size at which they will quote; however, the minimum quote size shall be at least the equivalent of 10 percent of the standard market size. ESMA provided further specifications of the requirements in Articles 9 to 11 of RTS 1. Other investment firms operating in the OTC sector are not subject to pre-trade transparency requirements.

 See Art. 8(1) as the equivalent rule for non-equity instruments.  Actionable indications of interest are defined in Art. 2(1)(33) MiFIR.  Recapture the controversial discussions about IOIs. See Ch. 2 (B.II.2.a. and III.1.b.).  Art. 14(1) MiFIR for equity/equity-like instruments and Art. 18(1) MiFIR for non-equity instruments, both provide similar requirements.  Cf. Moloney, EU Securities and Financial Markets Regulation, 488.  Art. 14(1), 18(1) MiFIR; cf. Moloney, EU Securities and Financial Markets Regulation, 488.

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ii. Pre-Trade Transparency Waivers In addition, like MiFID I, the new regime also provides exemptions and waivers in regard to pre-trade transparency acknowledging the benefits dark trading may bring for investors and market liquidity in general.⁵⁶⁵ However, addressing the concerns that were raised particularly with respect to dark trading and the issues resulting from its lack of pre-trade transparency, the EU Commission adjusted and restricted the extensive waiver regime for pre-trade transparency requirements as already provided in MiFID I.⁵⁶⁶ Under Article 4(1) MiFIR operators of RMs and MTFs trading in equity and equity-like instruments can apply for waivers to allow them to operate in dark trading without being subject to requirements to publish pre-trade data. Accordingly, four waivers are available that apply on a per-instrument basis: (1) reference price waiver, (2) negotiated transaction waiver, (3) large-in-scale waiver, and (4) order management facility waiver (for ‘iceberg orders’). Pursuant to Article 4(6) MiFIR ESMA is charged with specifying the operational details in RTS. Although these waivers were already available under MiFID I and the new regime relies on the same broad categories, specific adjustments and additional, more restrictive requirements were included in MiFIR. The most popular waiver, the reference price waiver applies to venues that execute orders at prices that are determined from another venue such as a primary exchange.⁵⁶⁷ By contrast to the MiFID I regime, MiFIR includes requirements regarding the reference market and the reference price.⁵⁶⁸ Accordingly, Article 4(2) MiFIR restricts the reference price to either the midpoint within the current bid and offer prices of the regulated market where the financial instrument was first admitted to trading or the most relevant market in terms of liquidity, or the opening or closing price of the relevant trading session if the trading occurs outside the continuous trading phase.⁵⁶⁹ In Article 4 of RTS 1 ESMA sets

 Cf. Busch/Ferrarini, Who’s Afraid of MiFID II?: An Introduction, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 1.01– 1.57, 1.30.  Cf. Gomber/Nassauer, 4 ZBB (2014), 250, 254. See also Moloney, EU Securities and Financial Markets Regulation, 481 highlighting that “[s]harp differences arose between those Member States adopting a restrictive approach and seeking to expose as much equity trading as possible to the price-formation process and those concerned to protect dark equity trading and the specialist liquidity and trading needs of traders, particularly institutional investors.”  Art. 4(1)(a) MiFIR. Cf. Moloney, EU Securities and Financial Markets Regulation, 482.  See Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.68.  The requirement under MiFID I that the reference price must be widely published and regarded as reliable has been maintained under MiFIR. The only difference is that such elements are codified as an implementing measure under MiFID I, whereas they are part of the Level 1 text

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forth the determination of ‘most relevant market in terms of liquidity’ for the reference price waiver. Accordingly, the most relevant market in terms of liquidity for a share, depositary receipt, ETF, certificate or other similar financial instrument shall be the trading venue with the highest turnover within the EU for that financial instrument. The national supervisory authorities shall calculate the turnover in respect of each financial instrument for each trading venue where that financial instrument is traded. Pursuant to Article 17(4) of RTS 1 the turnover is calculated by summing the results of multiplying, for each transaction executed during a defined period of time, the number of units of that instrument exchanged between the buyers and sellers by the unit price applicable to such transaction. Concerning the negotiated transaction waiver differences occur in respect of the admissible execution prices depending on the type of the transaction and the trading characteristics of the financial instrument being traded.⁵⁷⁰ The definition of negotiated transaction was extended to cover transactions in illiquid equity/ equity-like instruments that are dealt within a percentage of a suitable reference price.⁵⁷¹ The specific characteristics of the negotiated transaction for the negotiated transaction waiver are laid down in Article 5 of RTS 1. Accordingly, a negotiated transaction is a transaction which is negotiated privately but reported under the rules of a trading venue and where either two members or participants of that trading venue are involved by dealing on own account or on behalf of a client or where one member or participant of that trading venue is acting on behalf of both the buyer and seller or dealing on own account against a client order. Article 6 of RTS 1 sets forth the characteristics of negotiated transactions that are subject to conditions other than the current market price.

of MiFIR. ESMA, Questions and Answers on MiFID II and MiFIR transparency topics (Feb. 7, 2018), https://www.esma.europa.eu/system/files_force/library/esma70 - 872942901-35_qas_trans parency_issues.pdf (last visited Sept. 25, 2018), 40 – 41; Financial Conduct Authority, TR16/5: UK equity market dark pools – Role, promotion and oversight in wholesale markets (July 2016), 51.  ESMA, Questions and Answers on MiFID II and MiFIR transparency topics (Feb. 7, 2018), https://www.esma.europa.eu/system/files_force/library/esma70 - 872942901-35_qas_trans parency_issues.pdf (last visited Sept. 25, 2018), 41. Accordingly, execution prices differ as follows: (1) Negotiated transactions which are subject to conditions other than the current market price can be executed at any price in accordance with the rules of the trading venue; (2) Negotiated transactions which are subject to the current market price must instead comply with certain price conditions [set forth hereafter].  Art. 4(3)(b) MiFIR. Cf. Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.69.

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Another example is the large-in-scale (LIS) waiver which allows for orders that are deemed larger than the average market size.⁵⁷² The size of orders qualifying as ‘large in scale’ depends on the average daily turnover in a particular financial instrument that shall be calculated by the national supervisory authorities.⁵⁷³ Further specifications by ESMA in Article 7 of RTS 1 reveal that the classification of the orders according to the size is more detailed than the classification under the MiFID I regime.⁵⁷⁴ An order shall be considered large in scale if the order is equal to or larger than the minimum size of orders set out in Tables 1 and 2 of Annex II of RTS 1. Accordingly, the numbers for orders with a lower average daily turnover are less restrictive under MiFID II/MiFIR in comparison to MiFID I, but more restrictive for orders with a higher average daily turnover.⁵⁷⁵ Pursuant to Article 9(1) MiFIR waivers from pre-trade transparency obligations also apply to trading in non-equity instruments, considering the liquidity risks typical for trading in these instruments that is often dealer-based.⁵⁷⁶ In particular, Article 9(1)(c) MiFIR provides a waiver for non-equity instruments for which there is not a liquid market. According to ESMA, this waiver for illiquid instruments is special in that it does not apply to specific order types or sizes but that it renders all non-equity instruments eligible for a pre-trade transparency waiver if they are deemed illiquid under MiFIR and RTS 2.⁵⁷⁷

 Art. 4(1)(c) MiFIR.  Art. 7(1) of RTS 1. This provision should be interpreted as comprising single large orders but not aggregated small orders. For more details on this discussion see Thelen, Dark Pools – Schattenbörsen im Lichte US-amerikanischer, europäischer und deutscher Kapitalmarktregulierung (Dark Pools – Dark Trading Platforms in the Light of US-American, European and German Capital Market Regulation), 181– 183. See also ESMA, Final Report, ESMA’s Technical Advice to the Commission on MiFID II and MiFIR (Dec. 19, 2014), 181 et seq.  See also Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.75.  See also Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 9 providing a table with the minimum order size qualifying as ‘large-in-scale’ under MiFID II in comparison to MiFID I. While under MiFID I the minimum order size for financial instruments with an average daily turnover below 50,000 EUR was 50,000, under MiFID II the minimum order size is 15,000. Under MiFID I the order size did not increase until the daily turnover exceeded 500,000 EUR, whereas MiFID II provides a proportionate increase of the order size.  Cf. Rec. 2, 25 of RTS 2. See also Moloney, EU Securities and Financial Markets Regulation, 486.  ESMA, Questions and Answers on MiFID II and MiFIR transparency topics (Feb. 7, 2018), https://www.esma.europa.eu/system/files_force/library/esma70 - 872942901-35_qas_trans parency_issues.pdf (last visited Sept. 25, 2018), 32– 33. The reason behind this is that ESMA expects an extremely large number of instruments to be eligible for this waiver and thus, a per-instrument basis would not be practically enforceable.

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Another key change was made in the application procedure of the waiver regime. Whereas under MiFID I, waiver decisions were at the discretion of the national supervisory authorities but due to voluntary arrangements were in practice managed through ESMA,⁵⁷⁸ this process was formalized under MiFIR.⁵⁷⁹ Consequently, a national supervisory authority must notify ESMA and provide an explanation before granting a waiver under Article 4 MiFIR and ESMA must, within two months, issue a non-binding opinion to the national supervisory authority.⁵⁸⁰ Moreover, ESMA is empowered to monitor the waiver application and report annually to the EU Commission. Thus, overall, ESMA gained significant power to oversee the national supervisory authorities in respect to the pre-trade transparency waivers, while the power on the national level severely decreased and became subject to controls on the EU level. This highlights the general development in the EU securities markets regulation with a “more EU” approach. The waiver regime is often regarded as “the key battleground” on which the Member States sought to protect their national territory, given that the national supervisory authorities could impose their own tailored and distinct rules on trading venues and trading practices.⁵⁸¹ However, the new regime significantly limits and undermines this power.

iii. Post-Trade Transparency Requirements and Waivers Post-trade transparency requirements do not change significantly compared to MiFID I. They are, however, also extended to cover non-equity instruments, as provided in Articles 10 and 21 MiFIR. Pursuant to Article 7(2)(a) MiFIR ESMA is empowered to provide RTS to govern the post-trade transparency information that will be made available by trading venues and investment firms for each class of equity and equity-like instrument, including the required identifiers for the different types of transactions. Generally, post-trade transparency requirements apply to all trading venues, multilateral as well as bilateral. However, as provided in Article 13 of RTS 1 and Article 12 of RTS 2 investment firms are exempt from post-trade transparency requirements for certain types of transactions that are technical and cannot be characterized as transactions where an invest-

 Which at that time was still operating as the CESR, the predecessor of ESMA.  Busch/Ferrarini, Who’s Afraid of MiFID II?: An Introduction, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 1.01– 1.57, 1.32; Moloney, EU Securities and Financial Markets Regulation, 483.  Moloney, EU Securities and Financial Markets Regulation, 483.  Busch/Ferrarini, Who’s Afraid of MiFID II?: An Introduction, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 1.01– 1.57, 1.31.

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ment firm deals on own account.⁵⁸² Further details about the information to be published under the post-trade transparency requirements are laid down in Table 3 of Annex I of RTS 1. Concerning post-trade transparency requirements a few waivers may apply allowing a delayed post-trade publication of transaction details in order to protect certain transactions from liquidity and position risk.⁵⁸³ In Article 15 of RTS 1, ESMA sets forth the operational criteria and conditions under which trading venues can be authorized for deferred publication and monitor and submit reports about the applications of those waivers.⁵⁸⁴ Accordingly, deferred publication can be authorized if the transaction is between an investment firm dealing on own account other than through matched principal trading and another counterparty and the size of the transaction if equal to or exceeds the relevant minimum qualifying size (as specified in Tables 4 to 6 of Annex II of RTS 1). Where a national supervisory authority authorizes the deferred publication, the venue operator or investment firm shall make public the transaction no later than at the end of the relevant period set out in Tables 4 to 6 of Annex II of RTS 1.

e. Double Volume Caps for Dark Trading One of the key changes concerning dark trading are the so-called volume caps for equity instruments that apply to trading under the negotiated transaction waiver and the reference price waiver.⁵⁸⁵ According to Article 5(1) MiFIR, the volume caps are designed to ensure that the use of those waivers does not unduly harm price discovery.⁵⁸⁶ In regard to the negotiated transaction waiver the caps only apply to trades executed within the volume-weighted spread and do not apply to transactions in shares, depositary receipts, ETFs, certificates or other

 See also ESMA, Questions and Answers on MiFID II and MiFIR transparency topics (Feb. 7, 2018), https://www.esma.europa.eu/system/files_force/library/esma70 - 872942901-35_qas_trans parency_issues.pdf (last visited Sept. 25, 2018), 47.  Art. 7 and 11 MiFIR applying to equity/equity-like and non-equity instruments, and Art. 21 MiFIR applying to investment firms and SIs. See also Gomber/Nassauer, 4 ZBB (2014), 250, 255; Moloney, EU Securities and Financial Markets Regulation, 484.  Cf. Moloney, EU Securities and Financial Markets Regulation, 485.  Rec. 17 and Art. 5(1) MiFIR. Cf. Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.65.  Rec. 17 and Art. 5(1) MiFIR. Cf. Moloney, EU Securities and Financial Markets Regulation, 484.

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similar financial instruments for which there is not a liquid market and transactions subject to conditions other than the current market price.⁵⁸⁷ MiFIR provides two volume caps. The first one, constituted in Article 5(1)(a) MiFIR, provides a limit of 4 percent of the total volume of trading in a specific equity instrument that can be carried out on a single venue operating under the reference price waiver or the negotiated transaction waiver. The second cap, provided in Article 5(1)(b) MiFIR, prohibits trading venues across the EU to trade a specific equity instrument under the waivers if the total European trading volume of that instrument exceeds 8 percent of the total capitalization of all trading venues. A breach of the caps will lead to a suspension of either the single venue (if the 4 percent threshold is breached) or all venues (if the 8 percent threshold is breached) from trading under the waivers in the respective financial instrument for a period of six months starting within two working days of the report being published.⁵⁸⁸ Thus, the suspensions will essentially prohibit dark trading on the specified venue, or across all venues for that period.⁵⁸⁹ Pursuant to Article 5(4) MiFIR the caps are calculated based on data from the previous 12 months that is published by ESMA within five working days of the end of each calendar month. Under Article 5(9) MiFIR ESMA is charged with the development of draft RTS to specify the method for gathering and publishing data required for the volume calculation. The details for the required data report to ESMA are laid out in its draft RTS 3.⁵⁹⁰ This RTS covers in particular the content, frequency and format of data requests. Article 6 of RTS 3 constitutes the reporting requirements for trading venues and operators of a Consolidated Tape Provider (CTP)⁵⁹¹ for the purpose of the volume cap mechanism and methodology for the calculation of the volumes; Article 8 provides details on the requirements for ESMA to fulfill its publication obligation.

 Art. 5(1) subpara. MiFIR; Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.81; Moloney, EU Securities and Financial Markets Regulation, 484.  Art. 5(2), (3) MiFIR; Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 9; Detrixhe/Brunsden, European Dark-Pool Equity Trading Limits Won’t Work, Ferber Says, Bloomberg (Apr. 15, 2015), http://www.bloomberg.com/news/articles/2015 - 04-15/dark-pool-trad ing-limits-will-not-work-lawmaker-ferber-says (last visited Sept. 25, 2018).  Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 9.  RTS 3 in Annex I of MiFID II/MiFIR, in particular Rec. 9, 10 of RTS 3.  CTP is defined in Art. 4(1)(53) MiFID II as a person authorized to provide the service of collecting trade reports for certain financial instruments from RMs, MTFs, OTFs and Approved Publication Arrangements and consolidating them into a continuous electronic live data-stream, providing price and volume data per financial instrument. See for further explanation below C.II.3.f.

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In March 2018, ESMA published the first calculations of the double volume caps for January and February 2018.⁵⁹² The total number of financial instruments accounted 18,644 for January and 14,158 for February, of which 17 instruments for January and 10 instruments for February were traded under a waiver in excess of the 4 percent cap, and 727 instruments for January and 633 instruments for February were traded under a waiver in excess of the 8 percent cap.⁵⁹³ It is significantly important to point out that the double volume cap mechanism does not apply to the large-in-scale waiver. This may provide some leeway for market operators to prepare innovative solutions and trading functionalities for investors to bypass the new cap mechanism and thus, to allow them to continue extensive dark trading and protect their interests.⁵⁹⁴ However, it is suggested that this development may also have a positive effect for other market participants as it may restore the status quo ante. Accordingly, only a few dark pools will emerge for the for the execution of large orders, with the result that the market will consolidate and transaction costs of traders engaging in block transactions will fall.⁵⁹⁵

f. Distribution and Consolidation of Trading Data A primary weakness of the MiFID I regime was the poor quality and unreliability of transparency data and its inefficient distribution and consolidation.⁵⁹⁶ In response, the EU legislator implemented a new regulatory and supervisory framework with new regulations governing data distribution and consolidation as well as data reporting services.

 ESMA, Press Release, MiFID II: ESMA publishes double volume cap data (Mar. 7, 2018), https://www.esma.europa.eu/sites/default/files/library/esma71-99 -953_press_release_esma_ dvc_0.pdf (last visited Sept. 25, 2018).  ESMA, Press Release, MiFID II: ESMA publishes double volume cap data (Mar. 7, 2018), https://www.esma.europa.eu/sites/default/files/library/esma71-99 -953_press_release_esma_ dvc_0.pdf (last visited Sept. 25, 2018). The data is available at https://www.esma.europa.eu/ double-volume-cap-mechanism (last visited Sept. 25, 2018).  Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.100, 14.94– 14.99 analyzing in detail promising solutions by market operators launched in 2014 and 2015.  Thelen, Dark Pools – Schattenbörsen im Lichte US-amerikanischer, europäischer und deutscher Kapitalmarktregulierung (Dark Pools – Dark Trading Platforms in the Light of US-American, European and German Capital Market Regulation), 180.  CESR, Technical Advice to the Commission in the Context of the MiFID I Review – Equity Markets, Consultation Paper CESR/10 – 394 (Apr. 2010), 16, 20 – 21; Moloney, EU Securities and Financial Markets Regulation, 454, 494.

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The new regulations provided in the MiFID II/MiFIR regime govern two main subjects: publication and consolidation. They introduce (1) an obligation to offer pre-trade and post-trade transparency data separately, (2) a common publication system for SIs, and (3) a regulatory framework within which different ‘Consolidated Tape Providers’ compete for data consolidation. With respect to data publication, according to Article 12(1) MiFIR, trading venues and investment firms are required to unbundle their trading data and offer pre-trade and post-trade data separately.⁵⁹⁷ Generally, pre-trade transparency data for both equity/equity-like and non-equity instruments must be made available to the public on a continuous basis during normal trading hours.⁵⁹⁸ SIs are similarly required to make their pre-trade transparency data public in a manner which is easily accessible to other market participants on a reasonable commercial basis.⁵⁹⁹ In regard to post-trade transparency data of equity/equitylike and non-equity instruments, trading venues and investment firms must publish it as close to real time as technically possible.⁶⁰⁰ Pursuant to Article 13(1) MiFIR the information shall be made available free of charge 15 minutes after publication. The further specifications regarding the requirements under the new regime were delegated to ESMA.⁶⁰¹ In its draft RTS 3 ESMA sets out the provisions specifying the common elements with regard to the content and format of data that is to be submitted.⁶⁰² The second major achievement was made in regard to the consolidation of trading data. By contrast to the US market, consolidation of trading data in the EU is a difficult task due to the divergent approaches for consolidation and distribution of trading data. Basically, there were two models for data consolidation: (1) a public non-profit making monopoly model like in the US, and (2) a commercial monopoly model according to which several providers of consol-

 See also CESR, Technical Advice to the Commission in the Context of the MiFID I Review – Equity Markets, Consultation Paper CESR/10 – 394 (Apr. 2010), 23; Moloney, EU Securities and Financial Markets Regulation, 494; Hoops WM (2018), 205, 211.  Art. 3(1) and 8(1) MiFIR.  Art. 15(1) and 18(1) MiFIR.  Art. 6(1) and 10(1) MiFIR.  See, for instance, Art. 12(2) and 14(7) MiFIR.  See Rec. 3 of RTS 3 in Annex I of MiFID II/MiFIR. A detailed assessment is provided by Hoops WM (2018), 205, 209 – 210.

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idation services developed by the industry compete with each other under a regulatory framework that governs the consolidation procedure.⁶⁰³ The EU regulator chose the commercial model due to its flexibility and created a new framework governing “data reporting services”⁶⁰⁴, including Approved Publication Arrangements (APA), Consolidated Tape Provider (CTP), and Approved Reporting Mechanism (ARM). Pursuant to Article 4(1)(52) MiFID II an APA is a person authorized to provide the service of publishing trade reports on behalf of investment firms. As an attempt to improve the poor quality of transparency data, particularly from the OTC sector, that mainly resulted from the unconsolidated publication of trading data through different proprietary channels, the new regime requires investment firms, including SIs, to publish their post-trade transparency data through an APA.⁶⁰⁵ This requirement ensures that trading data in the OTC sector is more comparable and reliable and thus, of high quality for market participants. Article 64 MiFID II provides further requirements for information access and distribution. According to Article 64(2) MiFID II, the information made public by an APA shall include, inter alia, the identifier of the financial instrument, the price at which the transaction was concluded, the volume, the time and the price notation of the transaction, the time the transaction was reported, the code for the executing trading venue or SI (otherwise the code ‘OTC’) and, if applicable, an indicator that the transaction was subject to specific conditions. Pursuant to Article 4(1)(53) MiFID II a CTP is a person authorized to provide the service of collecting trade reports for certain financial instruments from RMs, MTFs, OTFs and APAs and consolidating them into a continuous electronic live data-stream, providing price and volume data per financial instrument.⁶⁰⁶ The CTP regime reflects the commercial approach by providing a regulatory frame-

 Cf. CESR, Technical Advice to the Commission in the Context of the MiFID I Review – Equity Markets, Consultation Paper CESR/10 – 394 (Apr. 2010), 21– 23, 24– 25; Moloney, EU Securities and Financial Markets Regulation, 454, 494.  The term is used in the MiFID II/MiFIR context, for example in Art. 1(1) and 4(1)(63) MiFID II.  Art. 20(1) and 21(1) MiFIR. See also ESMA, Questions and Answers on MiFID II and MiFIR transparency topics (Feb. 7, 2018), https://www.esma.europa.eu/system/files_force/li brary/esma70 - 872942901-35_qas_transparency_issues.pdf (last visited Sept. 25, 2018), 17. Accordingly, when a transaction is executed between two MiFID investment firms outside the rules of a trading venue, only the investment firm that sells the financial instrument concerned makes the transaction public through an APA (as clarified in Art. 12(4) of RTS 1 and Art. 7(5) of RTS 2).  See also the requirements for the trading venues and APAs set forth in Art. 6, 7, 10, 12, 13, 20, 21 MiFIR.

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work that sets forth the requirements for data consolidation but that relies on the market to set up its own providers that compete with each other within this framework.⁶⁰⁷ CTPs are subject to certain organizational and operational requirements laid down in Article 65 MiFID II. The details that shall be included in the information are set out in Article 65(2) MiFID II which are almost identical with those in Article 64(2) MiFID II. Accordingly, the data stream also identifies whether the transaction was executed through an SI or other bilateral OTC. The information must further include, where applicable, the fact that a computer algorithm within an investment firm was responsible for the investment decision and the execution. In addition, transactions executed under a transparency waiver must be flagged, indicating which of the waivers the transaction was subject to. Pursuant to Article 4(1)(54) MiFID II an ARM is a person authorized to provide the service of reporting details of transactions to national competent authorities or to ESMA on behalf of investment firms. As laid down in Article 26(1), (3) MiFIR investment firms which execute transactions in financial instruments are required to report complete and accurate details of such transactions to the competent authority as quickly as possible, and no later than the close of the following working day. These reports can be made either by the investment firm itself, by the trading venue the transaction was executed on, or by an ARM acting on behalf of the investment firm (Article 26(7) MiFIR). In the latter case, the ARM reports not to the entire market but to the competent supervisory authority. The obligations of ARMs, set forth in Article 66 MiFID II, are equal to those imposed on APAs and CTPs. Notably, Article 26(7) MiFIR also specifies who is responsible for the completeness, accuracy and timely submission of the reports and when this responsibility is transferred. Generally, the responsibility lies in the hands of the investment firms. However, where an investment firm reports details of those transactions through an ARM which is acting on its behalf or a trading venue, the ARM or trading venue shall be responsible for those failures, unless the ARM can prove that it met all organizational requirements laid down in Article 66(4) MiFID II. All data reporting services must be authorized by the competent national supervisory authority of their home member state and are also subject to that authority’s oversight.⁶⁰⁸ Remarkably, the new consolidation regime applies only to post-trade data because pre-trade data must be made available under shorter time scales so that a consolidation on EU level is technically challenging and

 Moloney, EU Securities and Financial Markets Regulation, 497; Hoops WM (2018), 205, 209.  See details in Art. 59 MiFIR.

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costly – apparently too challenging and too costly at the time of the implementation of the new MiFID II/MiFIR regime.⁶⁰⁹

g. Regulation of Algorithmic Trading and HFT Until the regulatory reform of the securities market regulation in the aftermath of the financial crisis of 2007– 2009, trading on own account, other than as an SI, remained mainly outside of regulatory supervision.⁶¹⁰ Although the MiFID I regime contained some trading-specific rules, it did not address algorithmic trading or HFT at all. Terrifying market disruptions, including the flash crash of May 6, 2010, detected the immense growth of complex trading technology and the severe risks to market stability generated by algorithmic trading and, in particular, by HFT.⁶¹¹ They also revealed that the former EU regime did not properly regulate these risks. Moreover, HFT was linked to the growth of dark trading which had already become a major topic of the MiFID I review.⁶¹² Hence, in a significant change to the MiFID I regime, the MiFID II/MiFIR regime explicitly addresses the concern that HFT is strongly related to market abuse and market manipulation and that it bears the risk of causing a disorderly and destabilized market due to erroneous orders, malfunctions and a general overloading of the electronic systems.⁶¹³ Even though the negotiations preceding MiFID II/MiFIR considered the option to prohibit HFT completely, the EU Commission chose a less restrictive approach, acknowledging the benefits of automated trading technology.⁶¹⁴ The final solution was to make HFT and other forms of algorithmic trading subject to specific regulatory requirements. This compromise is a result of the strong disagreement among the Member States about whether HFT is overall harmful and whether it should be restricted. While some Member States, for example the Netherlands, where some of the most active HFT firms are based, are generally strong proponents of HFT, other Member States, including France and Germany, consider HFT a form of

 Moloney, EU Securities and Financial Markets Regulation, 494.  E. g. exemption provided in Art. 2(1)(d) MiFID I.  Cf. Moloney, EU Securities and Financial Markets Regulation, 511.  Cf. Moloney, EU Securities and Financial Markets Regulation, 527.  Rec. 62, 68 MiFID II; Conac, Algorithmic Trading and High-Frequency Trading (HFT), in: Busch/Ferrarini, Regulation of the EU Financial Markets, 17.01– 17.62, 17.51; Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 501. See Ch. 2 (B.IV.1.) for risks generated by HFT.  Busch, 10 LFMR (2016), 72, 73; see also Rec. 59 and 63 MiFID II.

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market abuse and already have restrictions in place.⁶¹⁵ The regulations within the MiFID II/MiFIR framework are spread across the three levels of the legislative procedure.⁶¹⁶ The main part is laid out on the first level in MiFID II which, by contrast to MiFID I, excludes proprietary traders applying high-frequency trading techniques from the general exemption for proprietary trading, according to Article 2(1)(d)(iii) MiFID II, and makes them subject to strict provisions, including requirements for controls and monitoring.⁶¹⁷ Thus, high-frequency traders in the EU will need to apply for a license as an investment firm which then triggers the application of further organizational and capital requirements, causing a huge increase in operational costs.⁶¹⁸ Pursuant to Recital 64 of MiFID II, investment firms and trading venues applying algorithmic trading and HFT must have robust measures in place to ensure that their strategies do not create a disorderly  Conac, Algorithmic Trading and High-Frequency Trading (HFT), in: Busch/Ferrarini, Regulation of the EU Financial Markets, 17.01– 17.62, 17.17 referring to The Netherlands Authority for the Financial Markets, High Frequency Trading: The Application of Advanced Trading Technology in the European Marketplace, AFM (Nov. 2010), https://www.afm.nl/~/profmedia/files/rapporten/ 2010/hft-report-engels.pdf (last visited Sept. 25, 2018). In 2012, Germany introduced the High-frequency-trading Act (Hochfrequenzhandelsgesetz).  Other EU legislative acts also contain provisions governing the regulation of HFT. See Directive 2014/57/EU of 16 April 2014 on criminal sanctions for market abuse (Market Abuse Directive, MAD), published in Official Journal of the European Union, L173/179 (June 12, 2014) and Regulation (EU) No 596/2014 of 16 April 2014 on market abuse (Market Abuse Regulation, MAR), published in Official Journal of the European Union, L173/1 (June 12, 2014). For instance, Art. 12(2)(c) MAR renders certain HFT strategies as market manipulation. Further details are provided by Moloney, EU Securities and Financial Markets Regulation, 740 et seqq.; Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 494. For a critical assessment of the categorization of HFT strategies as market manipulation see Bayram/ Meier, WM (2018), 1295 – 1302.  See also Busch/Ferrarini, Who’s Afraid of MiFID II?: An Introduction, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 1.01– 1.57, 1.14; Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.62; Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 502.  Art. 17(2) MiFID II. Dietenberger, Systeme und Kontrollen in einem automatisierten Handelsumfeld (Systems and controls in an automated trading environment), in: Ellenberger/Clouth, Praktikerhandbuch Wertpapier- und Derivategeschaeft (Textbook on Securities and Derivatives Business), 939, para. 2572; Conac, Algorithmic Trading and High-Frequency Trading (HFT), in: Busch/Ferrarini, Regulation of the EU Financial Markets, 17.01– 17.62, 17.45. The capital requirements are set forth in Directive 2013/36/EU of 26 June, 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms (Capital Requirements Directive) published in Official Journal of the European Union, L 176/338 (June 27, 2013).

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market and cannot be used for abusive purposes.⁶¹⁹ Furthermore, they need to meet certain requirements introduced by MiFID II, in respect of the organization, the co-operation with supervisory authorities, and the stabilization of liquidity, and fulfil obligations regarding information and records-keeping.⁶²⁰ Article 48 MiFID II further contains rules applying to investment firms operating RMs, MTFs and OTFs.⁶²¹ Pursuant to Article 48(8) MiFID II, trading venues must have in place transparent, fair and non-discriminatory rules with respect to co-location and fee structure. This is an essential requirement to promote equal treatment among traders, particularly high-frequency traders.⁶²² Trading venues must at all times be able to identify orders generated by algorithmic trading, the algorithms used, and the relevant persons initiating those orders.⁶²³ Moreover, Member States shall allow RMs to adjust their fees for cancelled orders and may allow RMs to impose a higher fee for placing an order that is subsequently cancelled and to impose a higher fee on participants placing a high ratio of cancelled orders and those operating an HFT technique, in order to reflect the additional burden on system capacity.⁶²⁴ Hence, the regulation of the fee structure is one of the few areas where MiFID II offers some margin of discretion to the national legislators.⁶²⁵

 In this context, trading venues have to ensure that, for instance, their trading systems are resilient and that they have in place ‘circuit breakers’ that are able to halt or constrain trading during turbulent price movements. Cf. Art. 48(1), (4)-(5) MiFID II. See also Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.62; Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 502, 504 with further details in note 209.  See Art. 17(1)-(6) MiFID II. Cf. Busch, 10 LFMR (2016), 72, 75; Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 502; Conac, Algorithmic Trading and High-Frequency Trading (HFT), in: Busch/Ferrarini, Regulation of the EU Financial Markets, 17.01– 17.62, 17.46; Dietenberger, Systeme und Kontrollen in einem automatisierten Handelsumfeld (Systems and controls in an automated trading environment), in: Ellenberger/Clouth, Praktikerhandbuch Wertpapier- und Derivategeschaeft (Textbook on Securities and Derivatives Business), 939, para. 2526 et seqq., 2551 et seq., 2571 et seqq.  Art. 48 is also applicable to MTFs and OTFs pursuant to Art. 18(5) MiFID II.  Conac, Algorithmic Trading and High-Frequency Trading (HFT), in: Busch/Ferrarini, Regulation of the EU Financial Markets, 17.01– 17.62, 17.40.  Art. 48(10) MiFID II, Rec. 67 MiFID II. Cf. Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 505 – 506.  Art. 48(9) MiFID II.  Cf. Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 517 note 393; Teigelack, Market Manipulation, in: Veil, European Capital Markets Law, 225, 243.

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In addition, Article 48(6) MiFID II requires trading venues to be able to slow down the flow of orders, if there is a risk of their system capacity being reached, and to limit and enforce the minimum tick size that may be executed on the market.⁶²⁶ Since imposing higher price ticks makes it harder for a trader to step in front of another trader by offering the smallest possible price increment (known as the front-running strategy usually pursued by high-frequency traders), the tick size regulation is an “indirect form of HFT regulation”.⁶²⁷ The minimum tick size requirement may therefore likely reduce the amount of HFT. The MiFID II/MiFIR regime does not provide specific provisions regarding AT/HFT but it empowers ESMA to provide Level 2 measures, including Technical Advice for delegated acts and draft RTS and guidelines. In September 2015, pursuant to Article 17(7) MiFID II, ESMA published draft RTS to specify further details of the requirements laid down in Articles 17(1)-(6) and 48, 49 MiFID II.⁶²⁸ RTS 6, for example, sets forth certain pre-trade and post-trade controls and stress tests that apply to trading in all financial instruments. RTS 7 provides specifications on organizational requirements for RMs, MTFs and OTFs. RTS 10 specifies the requirements of trading venues to ensure that co-location services and fee structures are fair and non-discriminatory. RTS 12 provides details on the determination of a material market in terms of liquidity relating to trading halt notifications. Furthermore, ESMA issued guidelines on “systems and controls in an automated trading environment for trading platforms, investment firms and competent authorities” in February 2012.⁶²⁹ However, since the Board of ESMA comprises the supervisors of the Member States, which represented strongly differing

 The ‘tick size’ element is further specified in Art. 49 MiFID II. “A ‘tick’ is a minimum price movement by which an instrument’s price can move.” See IOSCO Technical Committee, Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency (July 2011), 17.  Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 505 notes 211 and 212.  See for a detailed analysis of ESMA’s draft RTSs Conac, Algorithmic Trading and High-Frequency Trading (HFT), in: Busch/Ferrarini, Regulation of the EU Financial Markets, 17.01– 17.62, 17.21, 17.24– 17.27 and Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 508 – 512.  ESMA, Guidelines, ESMA/2012/122 (Feb. 24, 2012), https://www.esma.europa.eu/system/ files_force/library/2015/11/esma_2012_122_en.pdf (last visited Sept. 25, 2018). These guidelines were supplemented by further guidelines covering specific topics, for example, guidelines on the calibration of circuit breakers and publication of trading halts under MiFID II, available at https://www.esma.europa.eu/sites/default/files/library/esma70-872942901-63_guidelines_on_ the_calibration_of_of_circuit_breakers.pdf (last visited Sept. 25, 2018).

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views on how to regulate HFT, the guidelines are of rather limited regulatory content and include primarily organizational requirements and provisions to prevent market abuse.⁶³⁰ They cover the operation of electronic trading systems by RMs and MTFs and the use of such systems, including the application of trading algorithms, by investment firms and aim at ensuring the continuity and regularity in the performance of automated markets and the compliance of investment firms with regulatory obligations.⁶³¹ ESMA also provides general guidance on the rules and procedures that trading venues and investment firms must have in place to ensure fair and orderly trading with respect to the electronic systems and automated trading activities.⁶³² In regard to HFT, guideline 5 requires that trading venues have “effective arrangements and procedures taking account of the specific supervisory arrangements/regulation in their Member State, which enable them to identify conduct by their members/participants and users that may involve market abuse (in particular market manipulation) in an automated trading environment”.⁶³³ ESMA also lists potential cases of market manipulation that could be of particular concern in an automated trading environment, which include pinging, quote stuffing, momentum ignition, layering and spoofing.⁶³⁴ This guideline particularly reflects the disagreement of the Member States on HFT as it leaves some leeway in regard to individual national regulations on HFT that may be more restrictive in some Member States than in others. Guideline 6 provides similar requirements for investment firms to minimize the risk that their automated trading activity gives rise to market abuse and market manipulation. Overall, the provisions are designed to ensure that trading venues and investment firms enabling and participating in algorithmic trading, particularly in HFT, provide a level playing field for all traders and operate resilient trading

 Conac, Algorithmic Trading and High-Frequency Trading (HFT), in: Busch/Ferrarini, Regulation of the EU Financial Markets, 17.01– 17.62, 17.18.  Guidelines 1 and 2 in ESMA, Guidelines, ESMA/2012/122 (Feb. 24, 2012), https://www.esma. europa.eu/system/files_force/library/2015/11/esma_2012_122_en.pdf (last visited Sept. 25, 2018). Cf. Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 501.  Guidelines 3 and 4 in ESMA, Guidelines, ESMA/2012/122 (Feb. 24, 2012), https://www.esma. europa.eu/system/files_force/library/2015/11/esma_2012_122_en.pdf (last visited Sept. 25, 2018).  See ESMA, Guidelines, ESMA/2012/122 (Feb. 24, 2012), https://www.esma.europa.eu/sys tem/files_force/library/2015/11/esma_2012_122_en.pdf (last visited Sept. 25, 2018).  Guideline 5 in ESMA, Guidelines, ESMA/2012/122 (Feb. 24, 2012), https://www.esma.europa. eu/system/files_force/library/2015/11/esma_2012_122_en.pdf (last visited Sept. 25, 2018). See Ch. 2 (B.IV.1.) for detailed definitions and descriptions of those trading strategies.

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systems to contribute to market stability and to prevent and identify market abuse. Although the requirements are aimed at regulating in particular HFT, including provisions on fee structure and manipulating trading strategies, they do not address the probably most important characteristic of HFT that may also be the trigger for most of the issues surrounding HFT: high frequency or in other words ‘speed’. There are no provisions dealing with latency which enables high-frequency traders to apply latency arbitrage strategies and front-run other traders’ orders.⁶³⁵ In sum, the provisions do not directly restrict HFT but rather cause burdensome organizational requirements and additional operational costs which may undermine the successful application of HFT and thus, may indirectly lead to a reduction of HFT activity. Since HFT is one of the primary incentives of institutional investors to move to the dark sector, the impact of the trading regulation under the MiFID II/MiFIR regime on dark trading largely depends on the limiting effect of the new regulations. The regulatory framework governing HFT extends beyond the MiFID II/MiFIR regime and includes, inter alia, the market abuse regime with provisions on market manipulation. A further assessment of these regulations on trading practices would, however, exceed the scope of this study as trading practices and, in particular HFT, are only indirectly related to dark trading.

4. Critique and Conclusion on the MiFID II/MiFIR Regime After having outlined the main regulatory changes provided by the MiFID II/ MiFIR regime in regard to dark trading, the remaining question is whether it constitutes an effective approach and may accomplish the two primary goals to ensure that organized trading takes place on regulated trading venues by moving OTC trading to trading venues that are subject to regulatory oversight, and to eliminate regulatory arbitrage that resulted from MiFID I. In contrast to the MiFID I regime, which did not address OTC trading and only mentioned it in one recital, rather randomly, the MiFID II/MiFIR regime directly addresses OTC trading and explicitly distinguishes it from other organized and regulated forms of trading. Overall, the EU regulator took a much more interventionist and prescriptive approach in tightening the regulations for trading venues and systematic internalizers operating in equity and equity-like instru-

 Cf. Conac, Algorithmic Trading and High-Frequency Trading (HFT), in: Busch/Ferrarini, Regulation of the EU Financial Markets, 17.01– 17.62, 17.20 criticizing that the MiFID II/MiFIR regime lacks provisions on latency and the organization of cross-market surveillance.

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ments and expanding the requirements to non-equity instruments. Significant changes were made in regard to venue classification, transparency requirements, and trading regulation.

a. Venue Classification The introduction of the new category OTF is intended to expand the regulatory oversight of OTC trading and may support the long-term goal to move OTC trading to regulated venues. However, the OTF category does not apply to equity instruments which accounts for a large amount, if not currently the largest amount, of OTC trading. Consequently, the standardized regulation and supervision of dark trades is very much limited. Critics therefore claim that it would be a prudent and necessary step to broaden the OTF category to include equity instruments.⁶³⁶ Overall it is highly disputable whether the primary goal can actually be achieved and whether the OTF category in its current form is the appropriate instrument to improve transparency and price discovery in the lit sector. Although other rules aim at improving transparency and reducing the amount of dark trading in equity instruments, concerns may be raised that MiFID II/MiFIR neither sufficiently addresses the regulation of dark trading in equity instruments nor effectively reduces regulatory arbitrage.⁶³⁷ There is no doubt, however, that the landscape of trading venues will drastically change. As the operation of dark pools in the form of broker-crossing networks (executing orders internally on a client-to-client basis without pre-trade transparency) is abolished under the new regime, the operators of those dark pools will have to transition to either multilateral trading venues or SIs.⁶³⁸ While operators of OTFs may be allowed to engage in matched principal trading, the trading venue is available only for non-equity instruments and requires the discretionary elements discussed previously. Thus, operators of broker-crossing networks trading in equity instruments will have to decide between MTFs and SIs. Given the costs and the loss of control over who has access to orders and how orders are matched, it seems unlikely that many brokers will convert their dark pools to MTFs.⁶³⁹ Rather, the SI category may become more important. Although SIs are not allowed to execute client-to-client orders but only to deal on their own account, they provide several benefits, including trading in price in-

   

O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 121. Cf. O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 121. Güllner WM (2017), 938, 940, 945. Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 10.

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crements smaller than the minimum tick size which is attractive, for example, to HFT firms.⁶⁴⁰

b. Transparency Regime Under MiFID II/MiFIR the transparency regulation in the EU was significantly enhanced with the result that it is applicable to both equity/equity-like and nonequity instruments. Further, the requirements for multilateral trading venues as well as investment firms, in particular SIs, were aligned. Overall, this will lead to more transparency in the OTC sector. However, it is unclear whether the increased level of transparency will also improve market quality and market efficiency. It is a general perception that too much transparency harms the markets.⁶⁴¹ The transparency regime under MiFID II/MiFIR, however, lacks a sufficient cost-benefit analysis and thus, is not based on reasonable grounds. The Europe Economics study supporting the drafting process of the new regulations was “somewhat equivocal”.⁶⁴² Consistent with the findings of this study provided in Chapter 2 the benefits of pre-trade transparency requirements are not clear but rather doubtful.⁶⁴³ Despite the general concerns about the actual relevance and value of pre-trade data, critics claim that the expansion of pre-trade transparency requirements to include in particular proprietary traders operating as SIs may increase the position risks of being exposed to the public if they act as liquidity providers, thereby increase their costs, and thus, in the long term, reduce their incentives to trade.⁶⁴⁴ This may significantly affect liquidity in the EU market. Critics claim that regulatory errors are very likely, intensified due to the great technical complexity and the extent to which this complexity has been driven by political and institutional compromise.⁶⁴⁵ Given the significant adverse impact on dark trading on the one hand, and the uncertain and doubtful benefits for

 Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 10; an overview of the benefits for dark pools to operate as SIs is provided by Thelen, Dark Pools – Schattenbörsen im Lichte US-amerikanischer, europäischer und deutscher Kapitalmarktregulierung (Dark Pools – Dark Trading Platforms in the Light of US-American, European and German Capital Market Regulation), 209 – 211.  Cf. the findings of economic studies evaluated in Ch. 2 (B.I.4.).  Moloney, EU Securities and Financial Markets Regulation, 498 note 375.  See Ch. 2 (B.I.4.).  Moloney, EU Financial Governance and Transparency Regulation: A Test for the Effectiveness of Post-Crisis Administrative Governance, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 12.01– 12.57, 12.05.  Moloney, EU Securities and Financial Markets Regulation, 498.

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the market on the other hand, the extension of the transparency regime could turn out to be a rather premature and hasty decision. Due to the unpredictable impact of the new transparency regime, critique is raised also in respect of the effectiveness of the administrative governance and in particular the role of ESMA which is charged with reviewing the transparency regulations.⁶⁴⁶ The extensive review of the new transparency regime as required under Article 52 MiFIR, particularly in regard to the waiver regime and the volume cap, is intended to overcome the current uncertainty about the specifications set forth in the draft RTS by ESMA and the general dearth of reliable economic evidence.⁶⁴⁷ However, MiFID II/MiFIR does not specify the procedure for the alteration and suspension of rules which prove to have an adverse and destabilizing effect.⁶⁴⁸

c. Double Volume Caps The new transparency regime is also significantly shaped by the introduction of the double volume cap – the key regulation under the MiFID II/MiFIR regime concerning dark trading.⁶⁴⁹ The volume caps have the effect of rigorously limiting OTC trading by banning dark trading above a certain threshold. Given the intensity of this form of regulatory intervention, they require sound justification. However, the volume caps are not clearly related to the thresholds evaluated by economists as thoroughly analyzed in Chapter 2. Rather, the thresholds set by the EU Commission may harm investors who seek the anonymity by trading in the dark sector, thus undermining the benefits of dark trading, without proving to have a positive impact on the market. Some anticipate that the double volume cap mechanism provided by the new regulation will not function because instead of restricting dark trading it

 Busch/Ferrarini, Who’s Afraid of MiFID II?: An Introduction, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 1.01– 1.57, 1.32.  The initial deadline of the review (March 3, 2019) was extended until March 3, 2020. See Art. 1(12) of the Regulation (EU) 2016/1033 of 23 June 2016, published in Official Journal of the European Union, L 175/1 (June 30, 2016). Cf. Moloney, EU Securities and Financial Markets Regulation, 499.  Moloney, EU Financial Governance and Transparency Regulation: A Test for the Effectiveness of Post-Crisis Administrative Governance, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 12.01– 12.57, 12.57; Busch/Ferrarini, Who’s Afraid of MiFID II?: An Introduction, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 1.01– 1.57, 1.32.  Cf. Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.65.

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will likely eliminate it.⁶⁵⁰ Most of the active dark pools in the EU exceed the caps and therefore would get in conflict.⁶⁵¹ As of August 7, 2018, there is a total of 1,262 instruments suspended, including 308 new breaches (246 equities for the 8 percent cap and 62 equities for the 4 percent cap), resulting in a suspension of trading in all new instruments in breach under the waivers (reference price and negotiated transaction waiver) from August 10, 2018 to February 9, 2019.⁶⁵² As the caps hinder the trade activity of dark pools it is likely to be expected that dark pools will either come up with alternative strategies to avoid transactions that might bring specific instruments into the threat of falling under the volume caps or stop acting in the EU markets and move offshore into foreign markets that still provide less regulation.⁶⁵³ Rob Boardman, CEO of ITG Europe, stated that “MiFID II will result in another wave of creativity from dark pools around block trades. As a firm, we are likely to move a regime where we will move as much as possible to the large-in-scale regime”.⁶⁵⁴ According to a market survey, more than 40 percent of 53 European based Global Heads of Dealing intend to increase their use of LIS waiver.⁶⁵⁵ Overall, numerous market participants have already responded with a broad range of initiatives that allow dark execution for their customers (mainly institutional in Detrixhe/Brunsden, European Dark-Pool Equity Trading Limits Won’t Work, Ferber Says, Bloomberg (Apr. 15, 2015), http://www.bloomberg.com/news/articles/2015 - 04-15/dark-pool-trad ing-limits-will-not-work-lawmaker-ferber-says (last visited Sept. 25, 2018).  ESMA, Press Release, MiFID II: ESMA publishes double volume cap data (Mar. 7, 2018), https://www.esma.europa.eu/sites/default/files/library/esma71-99 -953_press_release_esma_ dvc_0.pdf (last visited Sept. 25, 2018). The results of the double volume cap mechanism are published on a temporary basis on the ESMA website in spreadsheet format, available at https:// www.esma.europa.eu/double-volume-cap-mechanism (last visited Sept. 25, 2018).  See ESMA, Press Release, MiFID II: ESMA issues latest double volume cap data (Aug. 7, 2018), https://www.esma.europa.eu/press-news/esma-news/mifid-ii-esma-issues-latest-doublevolume-cap-data-2 (last visited Sept. 25, 2018). In the original Suspensions File the total amount of instruments was 1,275. However, it erroneously included 13 instruments that should not have been on the list. See ESMA, Press Release, Errata Double Volume Cap Data (Aug. 9, 2018), https://www.esma.europa.eu/press-news/esma-news/errata-double-volume-cap-data (last visited Sept. 25, 2018).  Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.94; Kasiske BKR (2015), 454, 455; Gomber/Nassauer, 4 ZBB (2014), 250, 258; Clarke, 8 LFMR (2014), 342, 349.  Cited in Cave, New Shades On Way for EU Dark Pool Trading, Rosenblatt Securities Inc. (Feb. 2, 2015), http://www.rblt.com/news_details.aspx?id=265 (last visited Sept. 25, 2018).  Cave, Traders fear EU rules will cause stumbles in the dark, Financial News (Jan. 10, 2017), http://www.liquidnet.com/uploads/1.10. 2017_-_Traders_fear_EU_rules_will_cause_stumbles_ in_the_dark_1.pdf (last visited Sept. 25, 2018); Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 11.

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vestors) not to be subject to the double volume cap regime.⁶⁵⁶ Most of these initiatives achieve this by providing market models and trading functionalities that avoid a classification of orders under the negotiated transaction and the reference price waivers, and try to bring these under the umbrella of the large-inscale waiver, which is not affected by the double volume cap mechanism.⁶⁵⁷ The initiatives can be divided into three categories: (1) new LIS venues, (2) new or modified order types to facilitate LIS trades on exchanges, and (3) high-frequency and intraday auctions.⁶⁵⁸ The new LIS venues use conditional order types which allow investors to rest large undisplayed orders while simultaneously working these orders via algorithms.⁶⁵⁹ If a block match is found for the large conditional order, investors have to confirm their conditional interest.⁶⁶⁰ Given their “conditional character”, the orders are not resting on that venue and thus, are not at risk of being frontrun.⁶⁶¹ By using minimum execution sizes the orders can be subject to the LIS waiver. The new or modified LIS order types on exchanges are orders with a minimum executable quantity above large-in-scale that can remain hidden even if partial executions reduce the order size below the LIS threshold.⁶⁶² Usually,

 Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.94, 14.95 – 14.99 with detailed descriptions of these initiatives. See also Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 11 et seqq.  Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.100. See also above in section C.II.3.d.ii.  A table including a description of the trading mechanism and a detailed assessment are provided by Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 11– 16.  Examples are Turquoise’s Plato Block Discovery launched in Oct. 2014 and BATS LIS launched in Dec. 2016.  Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 14; Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.98.  Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 14.  Examples include Deutsche Bank’s Volume Discovery Order (Deutsche Boerse) launched in Dec. 2015 and the Mid-Price Pegged Order functionality of the LSE (on SETS, the LSE’s primary electronic order book trading indexed securities) launched in Nov. 2015. See Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 15 and Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.97, 14.99.

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the hidden volume is available for matching against other hidden orders at the current midpoint of the order book.⁶⁶³ The high-frequency and intraday auctions do not rely on the LIS waiver but rather seek to provide an alternative approach to trading in a pre-trade transparent setting.⁶⁶⁴ Orders submitted to the auctions remain hidden, but when an auction becomes possible indicative prices and volumes will be displayed ensuring that they qualify as pre-trade transparent venues.⁶⁶⁵ The advantage is that the individual orders are dark and thus, cannot be detected and front-run by highfrequency traders, while, at the same time, they do not fall under a waiver as the auction mechanisms are pre-trade transparent, and thus, are not factored in the calculation of the double volume caps.⁶⁶⁶ These initiatives show that market participants will be innovative and creative to keep their dark trading opportunities alive to protect the interests of institutional investors and to prevent them from becoming subject to restrictions imposed by the double volume cap mechanism. Although the volume caps will likely decrease the amount of dark trading, they may also likely reduce trading in the markets in general and thus, adversely affect market quality and market efficiency.⁶⁶⁷ Given the fact that they cause a disruption of the usual trading strategies of institutional investors resulting in an increase of their execution costs, it is likely that some traders and operators of dark pools who cannot find or afford a satisfying alternative will refrain from trading or shut down their dark pools.⁶⁶⁸ This would lead to a detrimental de-

 Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.97, 14.99; Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 15.  Examples are BATS Europe’s Periodic Auctions Book launched in Oct. 2015 and LSE’s intraday auction launched in March 2016. See Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 15; Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.95.  Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 15.  Cf. Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 16; Gomber/Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.95.  However, not all observers agree that dark turnover will necessarily diminish. See Gomber/ Gvozdevskiy, Dark Trading Under MiFID II, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 14.01– 14.106, 14.105 notes 84, 85 referring to market participants stating that the volume caps are likely to increase the amount of larger dark trades and certain types and venues of dark trading that are not covered by the volume caps.  Cf. Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 9.

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crease in liquidity harming the market.⁶⁶⁹ Overall, the outcome and the effects of the volume caps are unpredictable. Given the likelihood of an unintended adverse impact on the market and market participants and the lack of sufficient provisions for the procedure to alter or suspend destabilizing rules, the volume caps, under MiFID II/MiFIR may not serve the primary purpose of the new regime.⁶⁷⁰

d. Regulation of HFT Despite the significant changes in the regulation of trading venues, the EU regulator also took a stricter and more prescriptive approach towards the regulation of trading practices by implementing a comprehensive regime governing algorithmic trading and in particular high-frequency trading. Acknowledging that these trading practices may increase systemic risks and cause disorderly markets due to the lack of human interaction, the requirements focus on the systems providing for algorithmic trading and HFT and aim at improving their resilience.⁶⁷¹ However, as the effects, especially on HFT with regard to market quality, are not yet fully known and rather unpredictable, the EU regulator refrained from implementing stricter provisions that would significantly inhibit or even directly restrict HFT, as it was often demanded during the negotiations of the new regulations.⁶⁷² Instead, the new provisions impose burdensome organizational requirements and high costs on those operating algorithmic trading and HFT. For instance, the provisions require to have in place fair and non-discriminatory rules with respect to co-location services and fee structure, which ought to ensure that every trader would be able to enter into respective agreements with the trading venue and benefit from those features. However, in practice, only

 Similar conclusion drawn by Thelen, Dark Pools – Schattenbörsen im Lichte US-amerikanischer, europäischer und deutscher Kapitalmarktregulierung (Dark Pools – Dark Trading Platforms in the Light of US-American, European and German Capital Market Regulation), 176.  See Thelen, Dark Pools – Schattenbörsen im Lichte US-amerikanischer, europäischer und deutscher Kapitalmarktregulierung (Dark Pools – Dark Trading Platforms in the Light of US-American, European and German Capital Market Regulation), 176, who suggests that the double volume caps may require further revision; however, he argues that there will not likely be a better solution than to focus on the achievement of threshold values and a temporal priority rule.  Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 513.  Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 518 referring to Prewitt, 19 MTTLR (2012), 131– 161, 158 who supports the introduction of a resting rule to make market abuse more difficult. This would, however, likely jeopardize the potential benefits of HFT.

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those able to afford the services can make use of it. Thus, although it is not required to establish a level playing field in absolute terms in that all market participants actually have access to those services and features, the regulations may likely result in a de facto discrimination.⁶⁷³ Consequently, the requirements and costs will have a considerable impact on HFT and reduce HFT activity in the market.⁶⁷⁴ This, in turn, may also lead to a reduction of dark trading in the long run, as HFT activity on the lit venues is one of the main incentives for other traders to move to the dark sector. However, this effect will largely depend on a cost-benefit analysis of traders engaging in HFT. As long as their benefits, mainly the monetary profit, exceeds the additional costs, HFT will likely prevail.⁶⁷⁵ Therefore, the question remains whether the EU regulator has taken the right approach towards HFT under the MiFID II/MiFIR regime. The answer to that, however, requires empirical data and thus, can only be given after a reasonable time of market observation. Similar to the new transparency regime, the regulations on HFT rely heavily on the measures developed by ESMA.⁶⁷⁶ Given the uncertain impact of restrictions on HFT, particularly with respect to the level of liquidity when markets are disrupted and there are few incentives to provide liquidity, ESMA’s ability to calibrate the regime in order to minimize unintended consequences will have a significant influence on the effectiveness of the new regulations.⁶⁷⁷ Although the guidelines are useful in order to respond market developments with relative speed, the compromise of the EU legislator not to tackle HFT strongly and to impose some margin of discretion regarding the transition into national law, may facilitate regulatory arbitrage. Since the Member States were and still are divided on the issue of HFT, some of them may implement stricter rules than other Member States.⁶⁷⁸ However, with respect to achieving a level playing

 Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 516 – 517.  Cf. Conac, Algorithmic Trading and High-Frequency Trading (HFT), in: Busch/Ferrarini, Regulation of the EU Financial Markets, 17.01– 17.62, 17.61; Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 518.  Apparently, HFT firms are highly profitable and some even claim to have never lost money on any trading day. Cf. Conac, Algorithmic Trading and High-Frequency Trading (HFT), in: Busch/Ferrarini, Regulation of the EU Financial Markets, 17.01– 17.62, 17.14 note 7.  See Rec. 63, 68 MiFID II.  Moloney, EU Securities and Financial Markets Regulation, 528.  Conac, Algorithmic Trading and High-Frequency Trading (HFT), in: Busch/Ferrarini, Regulation of the EU Financial Markets, 17.01– 17.62, 17.62.

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field and the targeted harmonization of capital markets law in the EU, Member States should refrain as much as possible from further ‘solo actions’.⁶⁷⁹

e. General Critique and Conclusion More general critique includes that the MiFID II/MiFIR regime is not conceptually coherent, reflecting the very strong national and institutional interest that are at stake and which have shaped the regime.⁶⁸⁰ For example, the enhanced transparency regime set out in MiFIR relies heavily on the concept of ‘illiquid markets’ in order to shield trading in non-equity instruments from transparency requirements and thus allowing trading in illiquid non-equity instruments.⁶⁸¹ However, while MiFIR attempts to acknowledge the increased liquidity risk that traders in non-equity instruments are exposed to by transparency requirements, the new rules will likely cause regulatory asymmetry with respect to the significant number of illiquid equity instruments in the EU market.⁶⁸² The new regime causes a huge interference of the government in the free market which may limit incentives to trade or expand the markets within the EU. Some argue that the new caps could “have unintended consequences, particularly if these caps are below harmful levels for the European market”.⁶⁸³ There is a risk that liquidity of equity instruments will move offshore to more accommodating venues, if the EU regulator does not amplify the conditions under which equity dark trading can take place on RMs, MTFs and SIs, and prevent regulatory asymmetry.⁶⁸⁴ As dark trading is a response to existing, reasonable market needs and as it is not yet clear whether dark pool trading has an overall negative impact on the market, the European approach is hardly justifiable.⁶⁸⁵ Overall, the structure of the MiFID II/MiFIR regime relies strongly on supervision of market participants by the trading venues and contains various provisions that require self-assessment of market participants and trading venues.⁶⁸⁶ Some argue that this appears to be a feasible way to ensure comprehensive su Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 513 with reference to the regulation of HFT.  Moloney, EU Securities and Financial Markets Regulation, 498.  Moloney, EU Securities and Financial Markets Regulation, 498. See above in section C.II.3.d.ii.  Moloney, EU Securities and Financial Markets Regulation, 498.  Comerton-Forde/Putniņš, 118 J. Fin. Econ. (2015), 70, 90.  Moloney, EU Securities and Financial Markets Regulation, 468.  Cf. Biedermann, 1 Public Finance Quarterly (2015), 78, 90.  Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 514.

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pervision and enforcement by using the technical knowledge and practical expertise of those who know the trading business best.⁶⁸⁷ However, it also causes the risk of potential conflict of interest and raises the general concern about evading responsibility by delegating regulatory power. Moreover, the impact of the new measures and provisions on the market is highly unpredictable. The effect of the new provisions, in particular the restrictions on the transparency waivers and the dark pool caps will vary among the Member States according to the different levels of dark trading.⁶⁸⁸ The legal uncertainty caused by the new regime has been intensified due to the amended legislative process under the Lamfalussy Process II that has turned EU securities market law into a “highly complex field of law” that makes it difficult or even impossible for market participants to comply with.⁶⁸⁹ Nevertheless, a final conclusion requires further market observation of the market impact of the new MiFID II/MiFIR regime and new empirical data collection.

D. Conclusion to Chapter 3 With the increasing development of alternative trading systems and the tremendous changes in market structures raising concerns about the risks to market quality and investor protection, the regulators around the world adjusted their regulatory frameworks and adopted new rules focusing on the promotion of competition and the enhancement of transparency. However, their success in minimizing the risks was significantly hampered by the emerging amount of dark trading. In response to the new challenges, regulators, particularly in the US and the EU implemented further reforms. Both, the US system and the EU system address the issues raised by dark trading as identified in Chapter 2. However, although the regulators pursue the same goals, they follow different approaches. Overall, the latest EU approach is more restrictive and interventionist than the US approach. As pointed out in the conclusion at the end of each analysis of the respective regulatory framework, none of them pro-

 Cf. Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 515.  The largest amount of dark trading takes place in the UK, hence, given the restrictions on the OTC sector, the UK market will be more affected than other markets, for example France where only a small amount of dark trading takes place.  Cf. Walla, Process and Strategies of Capital Markets Regulation in Europe, in: Veil, European Capital Markets Law, 39, 53.

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vide an efficient and effective regulation of dark trading to satisfactorily solve the issues. Both systems have their strengths and weaknesses. Thus, in order to evaluate which regulatory approach is more appropriate in regard to the specific challenges created by dark trading and to reveal regulatory gaps that require further intervention, it is of crucial importance to provide a thorough comparative analysis of both systems. Hence, the next and final Chapter 4 compares the similarities and differences of the US system and the EU system, identifies the strengths and weaknesses, and provides recommendations for future regulatory intervention.

Chapter 4 Final Comparison and Recommendations The assessment of the different regulatory frameworks reveals that both, the US and the EU, address dark trading and aim at imposing stricter regulations and enhancing supervision. However, although the regulators of the securities markets overall face the same issues and pursue the same goals, they follow different approaches. Mainly, those differences emerge from the different market structures. While the US system is characterized by the National Market System created by the Securities Acts Amendments of 1975 which is overseen mainly by a single authority, the SEC, the EU market is more fragmented and embedded in a treaty system that depends on several authorities to interact and collaborate. The different regulatory approaches are reflected in, for instance, the categorization of trading venues, the transparency regimes and the consolidation of trading data. As a result, the regulations differ in their impact on the market and their contribution to the primary objectives of securities regulation. Chapter 1 introduces the different terminology in the EU and the US in regard to trading venues and outlines the historical events and regulatory steps that caused for changes in the market structure and lay the foundations of the legislative frameworks in their current form. The main finding is that both, the US market and the EU market are equally confronted with the risks imposed by the increasing amount of dark trading. Chapter 2 sets forth the primary objectives of securities regulation and provides an evaluation of empirical and theoretical studies analyzing the issues raised in regard to dark trading. The main aim of securities regulation is to create a level playing field among the markets. Thereby, regulators interfere to achieve (1) investor protection, (2) market efficiency, (3) market quality, (4) market integrity, (5) market stability. The assessment of the empirical and theoretical studies provides evidence that dark trading is not harmful per se but that it may under certain circumstances pose a risk to the primary objectives. The main findings therefore suggest that regulators should not strictly prohibit dark trading but consider its benefits, in particular narrower spreads, reduced market impact costs and trading costs as well as lower risk of information leakage. However, they should address transparency, market fragmentation, informational asymmetries and supervision in regard to predatory trading strategies and HFT and base their regulatory intervention on a sufficient cost-benefit analysis. Chapter 3 provides an overview of the different regulatory frameworks, focusing on the US system and the EU system, and assesses in more detail the reghttps://doi.org/10.1515/9783110661873-007

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ulations specifically addressing dark trading. Both the US system and the EU system address the issues raised by dark trading but follow different approaches. Overall, each regulatory regime has its strengths and weaknesses and does not provide an entirely satisfactory solution to the regulation of dark trading. The US system is less restrictive and the application of its regulations on trading venues solely depends on quantitative criteria, i. e. the threshold of five percent of daily trading volume. Thus, it provides loopholes for dark pools to avoid the requirements specifically tailored to alternative trading systems. Furthermore, the US system does not directly address and regulate HFT. The EU system, on the other hand, is more interventionist, particularly with respect to the transparency regime. However, due to its complexity and especially the differences between equity and non-equity instruments, it also risks regulatory arbitrage. Another major weakness of the EU system is the consolidation of trading data. The remaining subject to this last chapter is the final comparison of the similarities and differences of the US system and the EU system in regard to the regulation of dark trading in view of the primary objectives of securities regulation (A.), in order to reveal regulatory gaps that require further intervention and provide recommendations (B.).

A. Final Comparison A comparative analysis of different legal approaches is generally valuable from an academic perspective in order to evaluate the weaknesses and advantages of the different systems and to improve the regulatory systems. However, in respect of the regulation of the securities markets, a comparative analysis is also important for another specific reason. Due to the effects of globalization, today, the different markets are strongly interconnected and market participants operate across the borders. Consequently, if the major jurisdictions widely differ in regard to certain areas, market participants may mitigate to other markets. Thus, it is of major relevance to compare the different systems and to align the regulations where necessary to avoid regulatory arbitrage and create a level playing field. The comparison between the US system and the EU system in regard to the regulation of dark trading reveals various similarities but also some key differences which are briefly pointed out in the following section. The main differences lie in (1) the categorization of trading venues, (2) the transparency requirements, (3) price discovery and fair access, (4) the consolidation of data, (5) the regulation of HFT, and (6) supervision of the markets.

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I. Categorization of Trading Venues The US system and the EU system have a similar regulatory approach in classifying trading venues among certain categories. However, their approaches differ in how they regulate those categories. The US regime distinguishes between national exchanges and broker-dealers and provides specific rules for each of those two categories. In contrast, the EU regime attempts to cover all organized trading and to align most of the requirements for different categories, e. g. RMs, MTFs and SIs, but provide exemptions for certain types of venues. Further differences exist in regard to the categorization of dark pools. The US system treats dark pools as ATSs and thus, requires them to register as broker-dealers. The major weakness of the US approach is that any ATS operating below the threshold of five percent of the average daily trading volume of a single security is not subject to the requirements and falls out of the regulatory regime.¹ Given the functional similarities of the different trading venues, quantitative criteria alone cannot justify differences in or even exclusion from regulation. Moreover, the system does not recognize the differences among the operation of dark pools and is not flexible to adjust to the emergence of new venue structures.² Overall, this likely causes regulatory arbitrage which may result in a market failure and thus, inhibit the achievement of the primary goals of securities regulation. The EU regulator, on the other hand, introduced more categories to address those differences. However, because the categories are too specific they do not cover all possible forms of trading venues.³ The result is that some dark pools are treated equally because they fall under the same category, whereas others which do not fulfill the specific requirements because their operation differs are treated as investment firms and thus, are subject to different regulations. Although the EU regulator aimed to close any gaps and cover all kinds of organized trading by the regulatory framework of the new MiFID II/MiFIR regime, the purpose was not fully achieved. The current approach may sooner or later again cause legal uncertainty and facilitate regulatory arbitrage as it is not flexible enough to adjust to the emergence of new trading venues and changes in the market structure. Thus, an institutional approach is not desirable and should be abandoned in favor of a cover-all approach that is not based on categories. Rather the regulatory framework should apply to all venues and traders and provide sufficient ex Cf. 17 C.F.R. § 242.301(b)(3), (5).  See the details of the different types of dark pools in Ch. 1 (A.III.2.b.).  The new category OTF was aimed at covering a large part of OTC trading, however, the final rule covers only venues operating in non-equity instruments.

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emptions or waivers based on qualitative criteria to recognize functional differences that require different or less regulatory intervention. This would prevent loopholes and regulatory arbitrage and provide for fair and orderly markets.

II. Transparency Regimes Both the US regulator and the EU regulator lately focused on enhancing their transparency regime, in particular the requirements for pre-trade transparency, to foster market efficiency and investor protection. However, there are significant differences with respect to the exemptions from the pre-trade transparency requirements that are essential to dark trading. In the US, dark pools, i. e. registered ATSs, are required to provide transparency by publishing quotes to data processing vendors. An exemption applies to ATSs that operate below the five percent trading volume threshold and that do not display quotes to more than one person. Thus, only those venues that do not exceed the threshold of five percent are actually dark.⁴ As pointed out previously, a major weakness of this approach is that the exemption is only based on quantitative criteria. This is, however, not sufficient as it provides an easy leeway to circumvent the regulations.⁵ Moreover, quantity alone is not decisive for whether a certain trading venue imposes risks to the market and thus, should be subject to stricter regulation, or vice versa. Making the application of transparency requirements dependent on quantitative criteria can therefore have a negative impact on market quality and efficiency. Hence, quantitative criteria likely lack sound justification. The EU, on the other hand, provides a variety of different exemptions in form of waivers based on qualitative criteria.⁶ These rules are more flexible and readily adjustable to different trading systems.⁷ Generally, this approach leads to more satisfying and justified results. With the implementation of the MiFID II/ MiFIR regime the EU made tremendous efforts to force dark trading back to the lit sector. The regulatory framework contains new limits on the exemptions to the pre-trade transparency requirements.⁸ Particularly, the double volume

 Cf. Boskovic/Cerruti/Noel, Comparing European and U.S. Securities Regulations, 25.  Cf. Kumpan, Die Regulierung außerboerslicher Wertpapierhandelssysteme im deutschen, europaeischen und US-amerikanischen Recht (The Regulation of Over-the-Counter Trading Systems in German, European and US Law), 359.  See for details on the waiver regime Ch. 3 (C.I.1.c., II.3.d.ii.).  Cf. Gadinis, 3 Va. L. & Bus. Rev. (2008), 311– 356, 338.  The changes in the waiver regime are assessed in Ch. 3 (C.II.3.d.ii.).

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caps limiting dark trading in a certain stock to four percent of total EU-wide trading on the venue or to eight percent of total EU-wide trading across the EU, rigorously bans dark trading above those thresholds. While traders in the US may circumvent the five percent threshold by spreading the trades across different platforms, the eight percent threshold in the EU prevents this manoeuvre as it takes into account the total amount of trading.⁹ However, as pointed out in Chapter 3, the double volume cap mechanism is strongly criticized.¹⁰ Most notably, the thresholds are not in line with the findings of empirical and theoretical studies. It is not clear on what grounds the thresholds of four percent and eight percent laid down in Article 5 MiFIR were calculated. The results of the literature review provided in Chapter 2 provide evidence that the EU volume caps are likely below harmful levels of dark trading.¹¹ Although the calculation of the exact threshold requires further empirical research, the current findings prove that the threshold differs, depending on (1) the type of dark trading, (2) the market capitalization of the relevant financial instruments, (3) the overall market structure, and (4) the level of market fragmentation. Since the thresholds of the volume caps do not take into account those distinctions, they may lead to unintended consequences. Even though the restrictions may decrease the amount of dark trading, the benefits of dark trading would be diminished as well. This could likely cause a market failure. Given the severe and far-reaching effects such rigorous regulatory intervention can have the EU approach may prove to be unreasonable and thus, unjustified. Despite the differences in the exemptions from pre-trade transparency, both regulatory systems aim at a higher degree of transparency but do not deal with the risks of excessive transparency which can adversely affect the primary objectives of securities regulation.¹²

III. Price Discovery and Fair Access Being concerned with the impact of dark trading on price discovery, both systems aim at finding additional solutions besides the efforts to enhance transpar-

 Thelen, Dark Pools - Schattenbörsen im Lichte US-amerikanischer, europäischer und deutscher Kapitalmarktregulierung (Dark Pools - Dark Trading Platforms in the Light of US-American, European and German Capital Market Regulation), 193 et seq. supporting the double volume cap mechanism.  Ch. 3 (C.II.4.c.).  See the summary of the results and conclusions in Ch. 2 (C.).  See further below in section B.III.

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ency to lower the impact and improve the price accuracy. However, due to the different market structures, the regulations widely differ. This is reflected, for instance, in the requirement set forth in Rule 611 of Regulation NMS which requires a trading venue to route the order to the trading venue that offers the nationally best bid or offer (NBBO). The EU does not have an equivalent rule.¹³ However, the EU imposed an even stricter regulation for those brokers executing orders in form of client-to-client matches by requiring them to send these orders to the lit sector, i. e. to RMs or MTFs.¹⁴ Although this rule does not directly improve price discovery it will certainly force more transactions to take place on lit venues instead and thus, indirectly promote price discovery. Nevertheless, it is likely that the number of SIs will increase instead since the MiFID II/MiFIR regime still allows internalization, i. e. the execution of orders against proprietary capital.¹⁵ Another difference that affects price discovery relates to the treatment of actionable IOIs which may effectively work like displayed quotations by informing recipients about available trading interest in a particular security in a dark pool.¹⁶ Hence, those IOIs may include information significant for price discovery. In the EU, IOIs are treated as bid and offers under Articles 3(1) and 8(1) MiFIR and thus are subject to the transparency provisions. In the US, however, the definition of “bid or offer” in Rule 600(b)(8) does not include IOIs. Even though the SEC proposed to amend the definition to include so called “actionable IOIs”, no changes were made at the time of this writing.¹⁷ Thus, the US system bears the risk that the use of IOIs in the dark may create a two-tiered access to information and adversely affect price discovery. The second issue related to dark trading that is addressed differently in the US and the EU is the access to different venues and prices.¹⁸ Generally, both systems provide that access to the facilities must be fair and non-discriminatory.¹⁹ The major weakness of the US system, again, is that the rules do not apply to dark pools operating below the five percent threshold.  Cf. Fox, MiFID II and Equity Trading: A US View, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 18.01– 18.127, 18.125.  So-called trading obligation provided in Art. 23(1) MiFIR. See Ch. 3 (C.II.3.c.). Cf. ComertonForde, Shedding light on dark trading in Europe (Aug. 2017), 8, 10.  Cf. Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 10.  IOIs are defined in Ch. 2 (B.II.2.). See also Ch. 3 (B.I.3. and C.II.3.d.i.).  SEC, Proposed Rules and Amendments, Regulation of Non-Public Trading Interest, Release No. 60997 (Nov. 13, 2009), Vol. 74 Fed. Reg. (Nov. 23, 2009), 61208, 61212– 61213. See details in Ch. 3 (B.I.3.).  Cf. Boskovic/Cerruti/Noel, Comparing European and U.S. Securities Regulations, 21.  17 C.F.R. § 242.301(b)(5); Art. 18(3), 53 (1) MiFID II for SIs, MTFs, OTFs and RMs.

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In regard to the access to prices, however, the US regulations are much more precise and stricter. Rule 610 allows the use of private linkages to provide access to venues and prices through indirect sources. It also limits the fees that trading venues can charge for access to protected quotations and prohibits the display of quotations that lock or cross protected quotations of other trading venues.²⁰ In contrast, the EU regime only requires RMs, MTFs and OTFs to provide access to prices on a reasonable commercial and non-discriminatory basis.²¹ SIs shall make public the quotes in a manner which is easily accessible to other market participants on a reasonable commercial basis.²² However, MiFIR does not clarify what constitutes a “reasonable commercial basis” to make quotes public as referred to in Article 15(1) MiFIR but leaves the specification to ESMA.²³ Moreover, the requirements do not apply to other forms of OTC trading.

IV. Data Consolidation The most obvious differences exist in regard to the consolidation of market data. While the US system, due to its structure as a National Market System, consolidates the best quotes available on each exchange and the executed transactions into a single tape, whereas the EU still provides data on a fragmented basis across multiple data providers.²⁴ Even though the MiFID II/MiFIR regime aimed to harmonize data consolidation, the divergent approaches of the different Member States once more led to difficulties in finding a sufficient solution to creating a uniform consolidation regime. Thus, the result, a regulatory framework that governs several competing providers of consolidation services established by the industry, is a compromise that is still detrimental with regard to the reliability and quality of the data. The main weakness of the EU data consolidation regime is that it applies only to post-trade data. The US regulators also took further steps to improve data consolidation and dissemination within the dark sector. Although ATSs are often exempt from extensive pre-trade transparency requirements and subject to only limited posttrade transparency requirements, FINRA established a uniform data reporting system and publishes comprehensive dark trading data accessible on its website.

 Cf. Boskovic/Cerruti/Noel, Comparing European and U.S. Securities Regulations, 21.  Art. 3(3), 6(2) MiFIR.  Art. 15(1) MiFIR.  Art. 15(5) MiFIR.  Cf. Fox, MiFID II and Equity Trading: A US View, in: Busch/Ferrarini, Regulation of the EU Financial Markets, 18.01– 18.127, 18.125.

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In contrast, the EU still lacks a sufficient system to consolidate and disseminate dark trading data.²⁵ Again the new regime demonstrates the EU regulator’s attempt to improve the consolidation of trading data including data from the dark sector by requiring also investment firms and SIs to publish data through certain authorized data service providers. However, the requirements only apply to post-trade data. As discussed in Chapter 3, the consolidation of market data plays a major role with respect to price discovery and the price accuracy and thus, for market efficiency. The better the consolidation of market data, the more reliable the data, and thus, the more accurate the prices are based on this information. If the data are consolidated into a single system, market participants are able to compare the data, while the fragmented consolidation and dissemination of data causes unreliability and may inhibit the best execution of orders. Hence, the EU regime that currently limits harmonized consolidation to post-trade data does not contribute to market efficiency, market quality and market integrity.

V. Algorithmic Trading Practices and HFT As discussed in Chapter 2, algorithmic trading practices and in particular HFT are strongly connected to dark trading. HFT is associated with an increasing demand for dark trading as a protection against the risks caused by predatory trading strategies often applied by high-frequency traders.²⁶ Although both regulators basically identified the same risks, the EU approach is far more interventionist than the US approach.²⁷ Under the MiFID II/MiFIR regime, the EU regulator extended the regulatory framework to cover investment firms engaging in algorithmic trading in particularly in HFT and imposed new regulations governing algorithmic trading and providing operational requirements.²⁸ In contrast, the US framework provides hardly any specific regulations governing HFT.²⁹ Rather, it primarily focuses on the trading venues and requires exchanges

 Cf. Biedermann, 1 Public Finance Quarterly (2015), 78, 88.  Cf. Moloney, EU Securities and Financial Markets Regulation, 527.  Cf. Moloney, EU Securities and Financial Markets Regulation, 528.  See Ch. 3 (C.II.3.g.).  General rules, including Sec. 9(a)(2), 10(b) SEA and Rule 10b-5 may apply. See for details Thelen, Dark Pools - Schattenbörsen im Lichte US-amerikanischer, europäischer und deutscher Kapitalmarktregulierung (Dark Pools - Dark Trading Platforms in the Light of US-American, European and German Capital Market Regulation), 280 et seq., 287 et seq.

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to have in place risk controls for market access and provide for sufficient capacity and resiliency to maintain the operational capability of fair and orderly markets.³⁰ Further, most of the monitoring and controlling of trading venues and trading practices is managed by the SROs, i. e. exchanges and in particular FINRA. However, broker-dealers who trade on their own account off-exchange are not required to be members of FINRA.³¹ This creates a loophole for high-frequency traders to avoid oversight by FINRA since many of them act as proprietary traders. Hence, the US system reveals some regulatory gaps. Given the risk of regulatory arbitrage that may appear on a global scale if the regulations of HFT widely differ and traders move to other markets, any efficient reduction of the risks imposed by HFT will depend on a closer collaboration between the US and the EU.³²

VI. Supervision Another significant difference exists among the supervision of the securities markets. In the US, supervision is largely centralized and delegated to the SEC. Additionally, the oversight of trading venues and trading practices in US market relies heavily on self-regulation imposed by SROs. Although the EU established ESMA as a centralized regulatory body that ought to contribute to harmonization and the standardization of EU-wide regulation and enforcement, its power is very limited and its role has been strongly criticized. In particular, ESMA’s Board of Supervisors comprises the national supervisors of the Member States and thus, the same conflicts of interest arise as on the legislative level. Moreover, the supervision of the national markets is still largely placed in the hands of the national supervisory authorities of the Member States. Although there are compelling reasons why the Member States insist to preserve their competences over the markets’ supervision, the lack of a single regulator causes uncertainty and the risk of regulatory arbitrage. It also inhibits efficient and effective prosecution of violations. The current enforcement actions in the US demonstrate how important supervision and enforcement is as it enables regulators to discover the actual concerns, to analyze whether the rules in place are effective and to reveal regulatory gaps that require  Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 519 – 520.  The exemptions are determined in 17 C.F.R. § 240.15b9 – 1(b).  Cf. Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 519 – 520.

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further intervention. The weaknesses in the EU system could also be overcome by enhancing self-regulation among the industry and fostering enforcement and prosecution. However, the EU regulators do not yet rely on means of self-regulation. Thus, there is a gap in the EU supervisory system that certainly calls for further actions.

VII. Conclusion Overall, the US regulator and the EU regulator address most of the issues raised in regard to dark trading. Both intensively enhanced their transparency regimes and improved the consolidation and dissemination of trading data. However, both systems have their weaknesses that adversely affect the primary objectives of securities regulation and some of the issues are not regulated in an efficient and effective manner. This may facilitate market failure, requiring and justifying regulatory intervention. The major weaknesses of the US system are the quantitative criteria to classify and differentiate ATSs from exchanges and the volume threshold of five percent that triggers the application of the provisions regulating ATSs. Since this threshold can easily be circumvented a wide range of dark pools operate outside the regulatory framework hampering the integration into the National Market System. Compared to the regulatory approach in the US, the recent European approach towards the regulation of dark trading is very paternalistic and much stricter and broader. But it also provides more stringency and flexibility. Further, the US does not treat actionable IOIs as quotations and thus, facilitates the creation of a two-tiered access to information and may inhibit price discovery, harming market efficiency and market quality. Moreover, the regulatory framework of the US still lacks sufficient regulation of HFT and predatory trading strategies while the MiFID II/MiFIR regime explicitly addresses algorithmic trading.³³ As pointed out, regulating HFT is inevitable in order to protect investors as well as market stability and to efficiently and effectively decrease dark trading in the long run. The major weaknesses of the EU system are the consolidation of data, the new double volume caps and the lack of options for short-term regulatory intervention and sufficient enforcement. Consolidation of market data in the EU is  Some EU Member States even argued that the EU regulator did not restrict HFT strongly enough and may impose stricter regulation on the national level. See Conac, Algorithmic Trading and High-Frequency Trading (HFT), in: Busch/Ferrarini, Regulation of the EU Financial Markets, 17.01– 17.62, 17.62.

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still fragmented since the EU does not have a single system, contrary to the US. This adversely affects price accuracy and fair access to information, overall harming market efficiency, market quality and market integrity. Further, the double volume caps may lack sound justification as the findings of economic studies do not support the level of the thresholds calculated for the volume caps as provided in Article 5 MiFIR. As pointed out, the new caps may drastically diminish dark trading. Since the thresholds are likely below the harmful levels of dark trading and do not differentiate between the type of dark trading and the market capitalization of the financial instrument, they may lead to unintended consequences and have a negative impact on market quality and market efficiency. The main disadvantage of this approach is that the EU cannot easily adjust to different developments and respond to specific regulatory needs by taking small steps, evaluating their effects and acting accordingly. Moreover, the EU system suffers from the divergent regulatory approaches among the Member States that often lead to conflicts of interests. Fearing the loss of competences, regulatory solutions are often half-hearted compromises resulting from political and institutional disagreements.³⁴ Although compromises are likely to find the highest level of acceptance and consent by the national legislators and market participants, the outcome is often of limited regulatory content and may, in some instances, lack clarity and stringency and rather cause uncertainty and regulatory loopholes. In addition, the process of law making in the EU is very lengthy and unwieldy as it is comprised of several steps, including first the discovery of the gaps of regulation by reviewing the current regulations³⁵, second the drafting of proposals for regulatory changes, third the legislative process, i. e. the Lamfalussy II Process³⁶, and finally the implementation on a national level.³⁷ Obviously, the pace of the market development is much faster and responses to market failure will often be too late. The US, on the other hand, may prove to be more efficient in regard to short-term intervention and supervision given the wider range of regulators on different levels. Since  See the introduction to the EU regulation of dark trading in Ch.3 (C.). One example is the regulation of HFT. The first proposals of MiFID II/MiFIR intended to completely prohibit HFT but the ultimate solution is less restrictive due to the strong opposition of some Member States (Ch.3, C.II.3.g.).  For instance, the review process for MiFID II/MiFIR started immediately after the implementation of the MiFID I regime and took several years.  See for more details Ch. 3 (C.II.1.a).  The first proposals for the MiFID II/MiFIR regime were published in October 2011 but the negotiations took until 2014 when the final compromise was made. The first deadline for the implementation on the national level was originally scheduled for January 3, 2017. However, it was delayed for another year until January 3, 2018.

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part of the regulation and enforcement is delegated to the exchanges who must register as SROs and who therefore have control over broker-dealers who must be a member of an SRO, regulatory responses can be imposed much faster. Moreover, Regulation and supervision in the EU also suffer from the lack of a centralized regulatory body as compared to the SEC in the US. Although the research shows that there are reasonable concerns caused by dark trading, a regulatory approach should focus on these concerns with the purpose to reduce the harmful risks up to the point where too much regulation may actually harm those that profit from dark pool trading. As long as their profit is not clearly unlawful and unjustifiable, there are no reasons to interfere in the market. Since the issues raised in regard to dark trading are very similar in the US and the EU, observing the market development will show how much the regulatory differences matter and provide indications regarding recommendations for further regulatory interventions.

B. Future Prospects and Recommendations The markets changed radically over the past decades and regulators tried to keep up and interfere accordingly to maintain market quality and investor protection. However, as pointed out in the previous section, not all of the regulatory steps prove to be efficient and effective. This leads up to the last and final question: What are the lessons learned from comparing the US system and the EU system in regard to the regulation of dark trading? The next part provides a summary of future prospects and recommendations for further research and regulatory action.

I. Dark Trading is Not the Sole Cause for Market Failure The first lesson is that regulators should take into consideration that many of the concerns are not only caused by dark trading but by a wide range of factors, including the general increase in market fragmentation and the developments in trading practices such as HFT. As evaluated in Chapter 2, market fragmentation is the main cause for the migration of liquidity causing a decrease in liquidity in the single trading venues. Consequently, high-frequency traders emerged as new liquidity providers. Due to their trading practices, however, other traders experienced great losses and were seeking for protection. Ultimately, this development spurred the increase of dark trading. Moreover, instances like insider trading and market abuse taking place in the dark sector may be facilitated by the

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lack of transparency and the resulting anonymity, however, they are not initially caused by dark trading. Therefore, proposals to restrict or ban dark trading simply because it increases fragmentation and provides less transparency are not sufficient and justifiable. On the contrary, they may bear the risk that participants in the dark sector, instead of moving back to the lit sector, will avoid the market completely or develop new ways to keep their orders anonymous which would cause new regulatory challenges and unintended effects on the market. As pointed out in Chapter 3 the recent restrictions on dark trading in the EU, in particular the double volume cap mechanism, caused market participants to find new strategies to cater the needs of those operating and trading in the dark sector in the presence of the new restrictions.³⁸ This provides evidence that the regulations will likely not have the intended effect of decreasing dark trading. Consequently, in order to improve overall market quality and investor protection in the long run, regulators should not solely focus on dark trading but address the other factors as well.

II. Regulators Should Consider the Benefits and Incentives As highlighted in Chapter 2, dark trading also provides benefits to the market by, inter alia, offering investors protection from predatory trading strategies and reducing trading costs. Dark trading has always been part of the trading environment. The tremendous increase in dark trading is caused not only by the technological and regulatory development during the past decades but also by a number of other incentives.³⁹ Probably, the main driver is the domination of high-frequency traders on the public exchanges.⁴⁰ Due to the comprehensive transparency requirements on the lit venues, high-frequency traders can take advantage of their speed and step ahead of other investors’ orders causing financial losses for those investors. Since “front-running” is not prohibited per se, other investors, mainly institutional investors, seek to hide from high-frequency traders in the dark sector. Restrictions on dark trading would therefore disadvantage institutional investors and thus, a significant part of the trading industry. The de-

 Ch. 3 (C.II.4.c.); cf. Comerton-Forde, Shedding light on dark trading in Europe (Aug. 2017), 11.  The incentives are analyzed in more detail in Ch. 1 (B.II.).  Today, HFT trades in Europe amount around one-third, see Petrescu/Wedow, Dark pools in European equity markets: emergence, competition and implications (July 2017), 9; in the US, HFT trades amount around 40 – 70 percent, see Hazen, Treatise on the law of securities regulation: Volume 5, 246.

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mand for dark trading will not vanish if regulators solely restrict or ban dark trading and the market will find solutions to continue dark trading.⁴¹ Hence, regulators should refrain from regulating dark trading too heavily and undertake a sufficient cost-benefit analysis. They should consider the benefits and focus on minimizing the incentives and making trading in the lit sector more attractive for traders who mitigated to the dark sector. Accordingly, changes to market structure were proposed with the aim of reducing the advantages associated with speed.⁴² Most prominent was the establishment of “Investors Exchange” (IEX), an ATS operating as a dark pool that imposed a “speed bump” to remove the speed advantage of high-frequency traders. IEX’s system holds back arriving orders for 350 microseconds before they are posted and executed.⁴³ Furthermore, the counterparties are notified about a completed transaction only after a 350microsecond delay. In addition, IEX provides for monitoring of trading practices that scares off traders seeking to pursue predatory trading strategies in the dark.⁴⁴ In 2016, IEX applied and received approval by the SEC to become a national securities exchange, despite the controversies and intense lobbying by users of HFT strategies.⁴⁵ IEX “serves as an ideal response to the conflicts of interest afflicting the stock market” and “creates fairness without federal intervention”.⁴⁶ If IEX proves to be successful, this venue design may likely incentivize institutional traders to move back to the lit sector. Another popular proposal by Budish, Cramton and Shim is to replace the current structure of continuous trading with frequent batched auctions.⁴⁷ In a continuous trading structure, orders are executed serially and receive execution pri-

 Cf. Bakie, Dark pool figures show growing global demand despite controversy, The Trade News (Jan. 19, 2016), http://www.thetradenews.com/Trading-Venues/Dark-pool-figures-showgrowing-global-demand-despite-controversy/ (last visited Sept. 25, 2018) citing Rob Boardman, CEO of ITG Europe who stated that “[t]here is a lot of demand for dark trading as the numbers show. Even with the upcoming caps in MiFID II, the market will find solutions to continue dark trading because it is proven to lower market impact and provide better execution.”  An overview of the most prominent proposals is provided by Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 44– 51.  See Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 45.  See Serbera/Paumard, 36 RIBAF (2016), 271, 285.  See Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 45; Conac, Algorithmic Trading and High-Frequency Trading (HFT), in: Busch/Ferrarini, Regulation of the EU Financial Markets, 17.01– 17.62, 17.14.  Marciello, 49 Suffolk U. L. Rev. (2016), 163, 179.  Budish/Cramton/Shim, 130 QJE (2015), 1547.

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ority based on time of arrival within a continuous sequence. According to the authors, this procedure provides opportunities for latency arbitrage and triggers an “arm’s race” for speed.⁴⁸ Thus, they suggest that rather than processing orders serially as they arrive, incoming orders should be aggregated in a uniformprice double auction. As a result, differences in speed would no longer provide a competitive advantage that benefits high-frequency traders. Instead, the actual value would matter, shifting the basis of the competition from speed to price.⁴⁹ In addition, to make lit venues more attractive, regulators should take up on the fee structure. Since another incentive of dark trading is the reduction of trading costs, lit venues could attract traders by financial benefits, including lower fees, rebates, and other options that would allow them to save costs. However, this requires further research and analysis of the effects of altering access fees that would extend the scope of this study.⁵⁰

III. Unlimited Transparency is Not a Sufficient Solution Furthermore, regulators should consider that transparency is not always the key to a successful achievement of the goals of securities regulation. Securities regulation is premised on a belief that transparent markets with effective disclosure provide the most efficient outcomes.⁵¹ There is no doubt that transparency generally improves market efficiency and market quality. However, the extent to which transparency is beneficial has its limits.⁵² Too much transparency can harm investor protection and market efficiency. One major incentive for investors to move to the dark sector is the lack of transparency that offers them protection from being exposed to predatory trading strategies by high-frequency traders. Excessive transparency, e. g. real-time disclosure of dark trading data, may therefore increase front-running in dark pools and scare off many investors from the

 Budish/Cramton/Shim, 130 QJE (2015), 1547, 1617.  Mahoney/Rauterberg, The Regulation of Trading Markets: A Survey and Evaluation (Apr. 2017), 45.  The SEC’s Equity Market Structure Advisory Committee (EMSAC) proposed an “Access Fee Pilot” to study the effects of altering access fee caps on rebates, order routing, liquidity, and other market quality outcomes. See EMSAC, Regulation NMS Subcommittee Recommendation for an Access Fee Pilot, June 10, 2016, https://www.sec.gov/spotlight/emsac/emsac-regulationnms-recommendation-61016.pdf (last visited Sept. 25, 2018).  Buckley, 36 Oxford J. Legal Studies (2016), 242, 248.  Cf. O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 122.

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market completely. Because this group of investors largely consists of institutional investors who are better informed and thus, are important contributors to price discovery, their displacement could have an unintended detrimental impact on market efficiency and market quality.⁵³ In order to sufficiently protect investors, it is necessary to differentiate among the types of investors and provide an environment that balances and satisfies the different and sometimes conflicting interests. An excessive transparency regime, however, likely harms the market. This demonstrates the sometimes difficult challenge for regulators to reconcile the different goals of securities regulation. Moreover, considering that post-trade information is the pre-trade information of future trades, it is doubtful to what extent pre-trade transparency is actually really necessary. In particular, it is unclear whether the nature and timing of the reporting of dark trading data is of major relevance. The results of theoretical and empirical research provide evidence that the lack of transparency in the dark sector is not a general concern and may only have a harmful impact on the market if the amount of dark trading exceeds a certain amount, depending on the type of dark trading. Given the significant adverse impact full transparency has on certain traders and venue operators, and on markets in general, regulators should be reluctant and careful with implementing stricter transparency requirements.⁵⁴ Moreover, they should request and consult more empirical research on the influence of transparency to evaluate the kind of data, pre-trade and post-trade, and the scope of transparency necessary to improve market efficiency. This research would also need to differentiate between the types of dark trading and among the volume of each security.⁵⁵ With respect to prospective changes to the transparency requirements, Fleckner suggests a compromise to make post-trade data available in real-time to the public but disclose dark pre-trade data in real-time only to those responsible for the price discovery on the public exchanges.⁵⁶ This would allow the benefits of dark trading by keeping the information private, while, at the same time, improv-

 The effects of the segregation of informed and uninformed traders across the lit and dark sectors are analyzed in Ch. 2. Researchers agree that the lack of informed traders in the lit sector severely harms the market.  Cf. O’Malley, 17 Trinity C.L. Rev. (2014), 94– 125, 123.  As highlighted in Ch. 2 (C.), the extent to which dark trading may harm the market differs according to the type of dark trading and the volume of the security traded on a particular dark venue.  Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 617.

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ing price discovery and making the securities’ prices more informative by secretly including the data in the price discovery process.⁵⁷

IV. Regulation of Trading Practices and HFT The regulation of trading venues will only be effective if regulators impose regulations on trading practices. As the rise of dark trading is mainly a response to the increasing occurrence of HFT in the lit sector, regulators should also focus on HFT and predatory trading strategies. Experts highly disagree on whether HFT harms market stability and investor protection and thus, should be restricted more heavily.⁵⁸ It is undisputed that HFT causes risks to the market but also improves market efficiency by providing liquidity. However, the analysis of HFT to the extent provided in this study shows that it is strongly related to dark trading as it provides a major incentive for a large number of traders to move to the dark sector. Sufficient and effective regulation of dark trading therefore requires regulation of trading practices, in particular HFT. Proposals were made, inter alia, to introduce a financial transaction tax since this would hurt high-frequency traders much more than other investors, given the small and frequent profits they earn.⁵⁹ Another solution would be to police trades through more granular reporting and monitoring, although this may be difficult to implement in practice.⁶⁰ Meanwhile, some investors adapted to the new environment and invented “low-frequency trading” (LFT), i. e. synchronizing lagged orders by slowing down faster orders so that they arrive at the exact same time.⁶¹ Further suggestions are made to implement a minimum resting period for orders or speed bumps to slow down trading.⁶² Such solutions however bear the risk to ban

 Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 617.  Cf. Cooper/Davis/van Vliet, 26 Bus. Ethics Q. (2016), 1, 12– 15, 18 and Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 622, both arguing strongly against a stricter regulation of HFT. Contrary arguments in favor of stricter regulations, including order cancellation taxes and resting rules, are made by Prewitt, 19 MTTLR (2012), 131– 161, 155, 161.  Cf. Zink/Selmier, 56 Business Horizons (2013), 715, 718.  Cf. Zink/Selmier, 56 Business Horizons (2013), 715, 718.  See Serbera/Paumard, 36 RIBAF (2016), 271, 284– 285.  Prewitt, 19 MTTLR (2012), 131– 161, 154, 158; Bernstein, The Importance of Shedding Some Light on Dark Pools, The New York Times (July 22, 2014), https://www.nytimes.com/2014/07/ 23/upshot/the-importance-of-shedding-some-light-on-dark-pools.html (last visited Sept. 25, 2018). See also above the design of IEX (section B.I.).

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HFT completely and may therefore be too rigorous given the benefits of HFT. Thus, further analyses are necessary to discover the optimal speed and frequency of trading.⁶³ As highlighted above, the US system and the EU system greatly differ with respect to the regulation of HFT even though they face similar issues and share similar concerns. Thus, a closer collaboration between the major markets will be necessary to avoid regulatory arbitrage that would cause high-frequency traders to move to the less restrictive market and therefore result in an unintended reduction of liquidity.⁶⁴ The EU regime may serve as a model example to efficiently capture and regulate HFT. However, given the differences in the market structure, any regulatory changes in the US require further empirical research.

V. The Type of Regulation Matters Another significant finding is that regulators should be aware of the constant and rapid development of the markets when deciding what type of regulation is appropriate for a certain intervention.⁶⁵ History shows that new technology and innovations are powerful drivers that cause the markets to become even more complex and trigger significant changes in market structure, including the proliferation of dark trading.⁶⁶ However, governmental regulators are hardly able to keep up with these changes due to the lengthy, unwieldy and cumbersome process of legislative decision-making.⁶⁷ Thus, the choice of the type of regulation is of major relevance to guarantee efficient and effective regulation and

 This question is subject to the economic study by Zhu/Du, What is the Optimal Trading Frequency in Financial Markets? (Dec. 23, 2016). See also Zhu, Flash Crash Seven Years on: What is the Optimal Market Speed?, Oxford Law Faculty (May 6, 2017), https://www.law.ox.ac.uk/busi ness-law-blog/blog/2017/05/flash-crash-seven-years-what-optimal-market-speed (last visited Sept. 25, 2018).  Cf. Lerch, Algorithmic Trading and High-Frequency Trading, in: Veil, European Capital Markets Law, 477, 518 – 519. For instance, countries in the Asian region are actively trying to attract HFT with less restrictive regulations.  The different types of regulation are listed in the introductory paragraph in Ch. 3. They include: (1) governmental regulation, (2) regulation by industry or federation of venue and self-regulatory organizations (SROs), (3) self-regulation (e. g. by individual investment firms by means of corporate responsibility), (4) regulation by venue (such as the NYSE).  Cf. Rühl-Wolfe, 7 Nw. Interdisc. L. Rev. (2014), 327– 362, 333.  Cf. Héritier, New Modes of Governance in Europe: Policy-Making without Legislating?, 4. See above section A.VII., note 35.

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improve social benefits. The US system provides for a large range of different types of regulation, including governmental and self-regulation, and may therefore prove to be successful, particularly, in regard to short-term intervention and supervision. The EU system, however, leaves hardly any room for market participants and venue operators to imply self-regulation.⁶⁸ One of the weaknesses of the MiFID II/MiFIR regime is that it relies on ESMA to further specify regulatory provisions by drafting a vast array of RTS and guidelines. These provisions, however, are of significant and fundamental importance for the practical application of the new regime.⁶⁹ Most of the specifications require further data analysis which proves to be difficult as the assessment of economic studies show since there is little if any reliable data in the EU market and most studies are theoretical rather than empirical. Despite the general concern about the delegation of regulatory responsibility, a comprehensive framework of operational differentiations and technical specifications causes legal uncertainty. First, market participants have to consult various different sets of rules. Second, they may be uncertain about how to comply with the rules and whether they meet the relevant requirements. And third, the close linkage to economic effects and the technical complexity of those specifications bear the risk of regulatory errors that could not be easily erased and rather lead to unintended consequences and market failure. Thus, the overall question is whether a legal regime should be based on technical specifications to an extent the new MiFID II/MiFIR regime does given the likelihood of regulatory error that may cause a harmful impact on the whole market. Considering that any fine adjustment is achieved more efficiently and effectively by those with hands-on experience and specific expertise, regulators should confer this task to the industry itself in form of self-regulation.⁷⁰ Another advantage of self-regulation is that it often leads to greater acceptance and less political resistance from decision makers and implementing actors.⁷¹ Moreover, self-regulation can overcome cross-border issues and issues due to differences among venues.

 See Walla, Process and Strategies of Capital Markets Regulation in Europe, in: Veil, European Capital Markets Law, 39, 62.  Cf. Moloney, EU Securities and Financial Markets Regulation, 498.  Cf. Coffee/Sale/Henderson, Securities Regulation, 688.  Héritier, New Modes of Governance in Europe: Policy-Making without Legislating?, 4; cf. Coffee/Sale/Henderson, Securities Regulation, 688.

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A model example of efficient and effective self-regulation by the industry is ⁷² IEX. It demonstrates how market participants can react to market structure developments in the short run and fix regulatory errors or fill regulatory gaps without governmental interference. Therefore, legislators should set core principles on an international, supranational and national level and design a regulatory framework (with a broader scope of application) but leave the specifications to the industry and market participants.⁷³

VI. Regulatory Intervention Should be Simple and Exceptional A more general critique that is not unique to the regulation of dark trading but concerns the regulation of the securities markets in general is that too much regulation creates a “moral hazard” and increases informational asymmetry.⁷⁴ Moreover, too much regulation can harm innovation and cause high costs, particularly, if compliance with the rules is too burdensome and costly and the risks of violating the rules and getting fined are too high. The current approach of the EU, i. e. intensive intervention by the governmental regulator based on a compromise lacking a sufficient evidence fundament and relying on an extensive post-implementation review, is therefore not desirable. Although an extensive post-implementation review of the new MiFID II/MiFIR regime is required, the consequences of this review are not clear. As shown by the MiFID I review process, the problematic regulations that led to adverse effects on the securities market were not removed but rather regulatory intervention intensified.⁷⁵ The MiFID I review process started almost immediately after the implementation of the regulatory regime. However, given the structure of the legislative process in the EU and the political and cultural differences, the review and in particular the negotiations concerning necessary changes were burdensome and time consuming. The result was a compromise, again with an unforeseeable outcome. Thus, regulatory intervention should be simple and exceptional. The primary goal is to create a level playing field among the market participants within a free

 See above section II. IEX is an ATS operating as a dark pool that imposed a “speed bump” to remove the speed advantage of high-frequency traders.  Cf. Fleckner, Regulating Trading Practices, in: Moloney/Ferran/Payne, The Oxford handbook of financial regulation, 596, 611– 612 referring to price formation as an example.  Cooper/Davis/van Vliet, 26 Bus. Ethics Q. (2016), 1, 1.  Cf. Moloney, EU Securities and Financial Markets Regulation, 499.

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market economy. It should be considered that the market exists to provide an effective place for investors to buy and sell financial instruments, but does not exist for any particular type of trading firm to make a profit.⁷⁶ Therefore, a careful cost-benefit-analysis is necessary to reveal regulatory gaps and errors and to choose the type of regulation that most sufficiently solves the issue with the least interference. Given the findings of the analysis of issues raised in regard to dark trading, provided in Chapter 2, the impact of dark trading on the market is not as harmful as often claimed. Moreover, severe concerns were raised by insider trading taking place in the dark sector and market abuse through certain trading strategies applied in the dark.⁷⁷ Although these issues are related to dark trading and may be facilitated due to the anonymity in the dark, they are not caused by dark trading. The successful investigations by the NY AG in the US demonstrate that, in order to efficiently address these issues, more supervision and enforcement of the current regulations are necessary. Therefore, regulations to lower the trading volume threshold, as proposed by the SEC, or implied by the double volume caps under MiFID II/ MiFIR do not serve the main purpose to reduce risks but rather just inhibit dark trading. It is not clear how such a regulatory step would appropriately address the issues. Rather, regulators should “encourage more connectedness between the pools and exchanges” and keep prosecuting violations of price rules of Regulation NMS or discrimination against their users.⁷⁸ Hence, regulators should focus on the factors that cause the increase of dark pools, the need to shield trading activity against predatory trading strategies, and not impose rules that de facto eliminate dark pool trading. Regulatory interference should be exceptional and surveillance of the trading venues and trading practices should be prioritized.

 Cooper/Davis/van Vliet, 26 Bus. Ethics Q. (2016), 1, 16.  Winter, Gazing Into ‘Dark Pools,’ the Tool that Enables Anonymous Insider Trading, CNBC (Jan. 23, 2013), https://www.cnbc.com/id/100400981 (last visited Sept. 25, 2018); Sullivan/Russello, ‘Dark Pool’ Trading Is Not Shielded From Regulatory Spotlight, New York Law Journal (Jan. 31, 2013), http://www.newyorklawjournal.com/id=1202586322320/%27Dark-Pool%27-Trading-Is-NotShielded-From-Regulatory-Spotlight?slreturn=20140510172105 (last visited Sept. 25, 2018).  Crudele, 9 Brook. J. Corp. Fin. & Com. L. (2015), 569, 590.

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VII. Conclusion The analysis and the different reactions towards the concerns about dark trading show that it cannot easily be determined whether more or less regulation is beneficial. Certainly, it is a mistaken belief to assume that dark trading is harmful to the market per se and thus, should be heavily restricted or even banned. Focusing solely on the regulation of dark trading without taking into account the benefits as well as the incentives that led to the increase in dark trading will have unintended consequences and detrimental effects. Before taking further steps to interfere, regulators should examine empirical evidence and provide a sufficient cost-benefit analysis, considering the benefits of dark trading. Such an analysis or market evaluation should provide more information about the amount of dark trading that actually has a negative impact on the market and causes harm to market participants. Thus, unless there is strong empirical evidence that a certain type of dark trading or a certain amount of dark trading harms the market and its participants, regulators should refrain from too much and heavy regulatory intervention and rather leave room for self-regulation, especially where short-term solutions are most efficient and effective.

Summary of the Final Conclusions Conclusions on the development and the classification of dark trading: (1) Over the past decades the securities market structures worldwide have been transforming. The current structure of the securities markets, particularly in the US and the EU, can be described as (1) highly technical and complex, (2) vastly fragmented, (3) with a high level of trading in the OTC sector. Recently, the third factor has raised severe concerns and gained more attraction by regulators and market participants. It is referred to as ‘dark trading’ due to its key characteristic not to disclose any trading information to the public prior to the execution of a transaction, as it is required for other trading venues, particularly public exchanges. (2) The term ‘dark trading’ is very broad and can include (1) dark orders, i. e. reserve or non-transparent order types, also referred to as hidden orders, on lit markets that interact with lit order flow, (2) trading in so called dark pools, a type of ATS, and (3) broker-dealer internalization (internalization of order flow by brokers acting as principals). Dark trading venues often use the prices on the lit venues as reference prices to determine their prices. Because dark trading does not provide pre-trade transparency, dark orders do not contribute to the price discovery process that takes place on the lit venues. (3) There are three main factors that led to the current market structure and the increase in dark trading: (1) the technical development and the innovation of HFT strategies, (2) regulatory changes enhancing competition, (3) globalization enabling cross-border activity. Furthermore, dark trading provides certain benefits that incentivize investors, particularly institutional investors, to move to the dark sector. Those benefits include the minimization of information leakage, the reduction of trading costs, and access restrictions to dark trading venues. The rapid increase of dark pools in international markets implies and demonstrates that there is a strong need for the benefits provided by dark trading. (4) Market participants and experts disagree on whether the overall impact of dark trading is positive or negative. There are two main views on the impact of dark trading on market quality: One side believes that dark venues have positively contributed to market innovations, competition, and reduced execution costs, while the other side argues that dark trading has a negative impact, in particular, on transparency and the quality of price discovery.

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Summary of the Final Conclusions

Conclusions on the impact of dark trading on the market and market participants: (5) Regulatory intervention may be necessary if dark trading adversely affects the primary objectives of securities regulation and causes market failure. The primary objectives of securities regulation are (1) investor protection, (2) market efficiency, (3) market quality, (4) market integrity, (5) market stability. Any restrictions on dark trading can only be justified if the negative effects outweigh the positive. This requires a careful cost-benefit analysis of the pros and cons of dark trading based on empirical and theoretical research. (6) Overall, the literature review presents a differentiated picture of the effects of dark trading on the market. This may be due to the lack of empirical data available from the dark sector, the different models used in theoretical studies and the different market structures. Following the empirical results and conclusions in the academic literature, regulators should address (1) transparency, (2) market fragmentation, (3) informational asymmetries, and (4) supervision in regard to predatory trading strategies and HFT. (7) With respect to the lack of transparency and the impact on price discovery, researchers found that dark trading leads to partial segmentation of traders resulting in a disproportionate dissemination of uninformed traders in the dark and informed traders in the lit market. They largely agree that a high level of dark trading, exceeding a certain threshold, therefore adversely affects price discovery and market quality. This threshold, however, depends on the type of dark trading and the market capitalization of the stock. (8) Concerning the impact of dark fragmentation, researchers found that it leads to a shift of liquidity from the lit market to the dark market which likely increases trading costs and adverse selection risk. The economic results provide evidence that the negative effects have an overall harmful impact if dark trading exceeds a certain threshold, which may differ among the markets based on the level of fragmentation. (9) In regard to the concerns about fair access, there is no clear evidence that access restrictions in the dark sector have a harmful impact on the market. The public has access to sufficient trading opportunities on the lit venues and regulators already imposed rules on fair and non-discriminatory access for dark trading venues. Moreover, some researchers found that dark pool exclusivity may lead to higher execution quality for large trades, improving market quality. However, due to the lack of transparency, the public has only limited or no access to valuable information in the dark sector. Although access to information does not per se justify regulatory intervention,

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263

a high level of dark trading can cause informational asymmetries to an extent that harms market efficiency. (10) The latest enforcement actions by the NY AG provide evidence that dark trading facilitates the practice of predatory trading strategies, which are mainly pursued by high-frequency traders, and thus, can indirectly harm market integrity and investor protection. However, the underlying issue is the lack of supervision and enforcement, which exists irrespectively of the dark nature of the venue, as regulators have difficulty to detect and monitor predatory trading strategies, whether they are pursued on a lit venue or dark venue. Although there is not enough evidence about the market impact, theory suggests that operators of dark venues will likely prevent negative effects by means of self-regulation. Therefore, regulators should be careful when imposing restrictions on dark trading, as they may not be justified, and rather should first address HFT and predatory trading strategies by enhancing supervision and enforcement. (11) The literature review provides evidence that dark trading is not harmful per se and its impact correlates with several other factors. Hence, regulatory restrictions can only be justified if they sufficiently consider (1) the level of market share of dark trading, (2) the type of dark trading, (3) the level of liquidity and market capitalization of the relevant financial instruments, (4) the market structure and the level of market fragmentation, and (5) the influence of HFT on the effects of dark trading.

Conclusions on the comparison of the regulatory approaches in the US and the EU: (12) In order to pursue the primary objectives of securities regulation, regulators worldwide agreed on the following core elements of the regulation of dark trading: (1) regulatory authorization and general supervision of trading venues, (2) fair and equitable rules regarding the operation of trading venues, (3) transparency, (4) fair access to information and trading venues, (5) reporting of trading data, (6) prohibition of manipulation and other unfair trading practices. However, the regulators chose different approaches, resulting in a variety of sets of rules across the jurisdictions. Overall, most jurisdictions do not generally prohibit dark trading but allow for the operation of dark pools and the execution of dark orders on lit venues. Differences exist particularly in regard to the classification of trading venues and how they are integrated in the market structure, and further in regard to the level of transparency and data reporting requirements as well as fair access requirements.

264

Summary of the Final Conclusions

(13) The US approach is to create a single market that integrates the various different trading venues and promotes competition, ensuring transparency, fair market access and the consolidation of data. Trading venues are classified among ‘exchanges’ and ‘alternative trading systems’, which must be registered as ‘broker-dealers’. They are subject to specific regulations, including transparency, reporting and fair access requirements. In regard to transparency requirements, trading venues must display their bid and offers. Exemptions apply to ATSs, which operate below the threshold of five percent of the aggregate trading volume in a specific financial instrument and to large size customer orders. Therefore, those ATSs and orders are considered ‘dark’. With respect to fair access requirements, operators of ATSs operating below the five percent threshold also have a large margin of discretion to restrict the access to their venues. (14) The major weaknesses of the US system are the institutional approach towards the regulation of trading venues and the quantitative criteria that limit the scope of application of the requirements for ATSs. The categorization of trading venues only as either national exchanges or broker-dealers in the form of ATSs does not efficiently reflect the broad range of different venues and may likely fail to capture large parts of the trading industry by the regulatory framework. Moreover, the application of the transparency and fair access requirements solely depends on quantitative criteria, i. e. the five percent threshold, and does not consider other qualitative criteria, including functional similarities. Since exceeding the threshold can be easily avoided, there are a large number of dark pools operating outside the regulatory framework. Consequently, the objectives pursued by the regulations are drastically inhibited. In addition, the US does not treat actionable IOIs as quotations and thus, facilitates the creation of a two-tiered access to information. Furthermore, the regulatory framework does not sufficiently address the issues caused by HFT and predatory trading strategies. In particular, it lacks effective safeguards to inhibit information leakage and frontrunning. (15) The EU system differentiates between regulated markets, multilateral trading facilities, organized trading facilities and systematic internalizers. They are all subject to similar extensive transparency requirements. Exemptions apply to those operating under a specific transparency waiver. There are three pre-trade transparency waivers available: the reference price waiver, the negotiated transaction waiver, and the large-in-scale waiver. Since the implementation of the MiFID II/MiFIR regime, the reference price waiver and the negotiated transaction waiver are subject to a double volume cap mechanism that limits the application of those waivers to either 4 percent

Summary of the Final Conclusions

265

of the total trading volume in a specific equity instrument on a single venue or to 8 percent of the total trading volume on all trading venues across the EU. The EU legislator further aligned the requirements regarding the operation and access restrictions. Further, under the MiFID II/MiFIR significant changes were made to enhance the consolidation of data by establishing a regulatory framework within which different service providers compete for data consolidation. (16) The major weaknesses of the EU system are the new double volume caps, the consolidation of data, and the lack of options for short-term regulatory intervention and sufficient enforcement. The volume caps are only based on quantitative criteria and do not consider other factors, in particular the level of liquidity and market capitalization of the relevant financial instruments. Hence, the caps may be below harmful levels of dark trading and therefore cause unintended detrimental effects. In addition, the volume caps may not be effective as they do not apply to the large-in-scale waiver and may therefore provide some leeway for market operators to bypass the new cap mechanism and allow them to continue dark trading. Furthermore, consolidation of market data in the EU is still fragmented since the EU does not have a single market system, contrary to the US. This adversely affects price accuracy and fair access to information. Another main disadvantage of the EU system is that the divergent regulatory approaches among the Member States often lead to conflicts of interests resulting in regulatory compromises. Due to the comprehensive legislative process and the lack of a centralized supervisory body, the EU legislator cannot easily adjust to different developments and effectively supervise regulatory compliance across the Member States. (17) Both, the US system and the EU system address the concerns raised by dark trading but neither provide an efficient and effective regulation of dark trading to satisfactorily solve the issues arising. The latest EU approach is more restrictive and interventionist than the US approach. Although this minimizes regulatory gaps, it may also limit incentives to trade, especially for institutional investors who are the main beneficiaries of dark trading. This would adversely affect liquidity in the EU market. The US approach, on the other hand, is not stringent and may cause regulatory arbitrage and informational asymmetries. However, the US may prove to be more efficient in regard to short-term intervention and supervision, given that part of the regulation and enforcement are governed by self-regulation. A common detriment of both systems is that the exemptions from transparency requirements which determine to what extent dark trading is allowed or restricted are not based on sufficient economic evidence. Both, the five per-

266

Summary of the Final Conclusions

cent threshold of the US system and the double volume caps of the EU system are only based on quantitative criteria and do not consider the criteria that is relevant to determine the harmful impact of dark trading as examined in the literature review. This concerns particularly (1) the level of market share of dark trading, (2) the type of dark trading, (3) the level of liquidity and market capitalization of the relevant financial instruments.

Conclusion on the assessment of the regulatory approaches taking into consideration the economic findings (18) The institutional approach of both, the US and the EU, is not flexible enough to adjust to changes in the market structure, including the emergence of new trading venues, and facilitates regulatory arbitrage, thereby creating a two-tiered market. It should therefore be abandoned in favor of a cover-all approach that is not based on categories. The regulatory framework should apply to all venues and traders and provide sufficient exemptions or waivers, where the regulatory requirements cause an unjustifiable interference or harm the market and its participants. (19) Although the research shows that there are reasonable concerns caused by dark trading, focusing solely on the regulation of dark trading without considering the benefits incentivizing dark trading will have unintended consequences and detrimental effects. Before taking further steps to interfere, regulators should examine empirical evidence and provide a sufficient costbenefit analysis in regard to dark trading. Such an analysis or market evaluation should provide more information about the amount of dark trading that actually has a negative impact on the market and causes harm to market participants. The relevant threshold may differ among the markets depending on the type of dark trading and the market capitalization of the relevant financial instruments as well as the overall market structure and the level of market fragmentation. (20) Proposals to restrict or ban dark trading simply because it increases fragmentation and provides less transparency are not sufficient and justifiable. On the contrary, they may bear the risk that participants in the dark sector, instead of moving back to the lit sector, will avoid the market completely or develop new ways to keep their orders anonymous. This would have unintended detrimental effects on the market. Unless there is strong empirical evidence that a certain type of dark trading or a certain amount of dark trading harms the market and its participants, regulators should refrain from too much and heavy regulatory intervention and leave room for

Summary of the Final Conclusions

(21)

(22)

(23)

(24)

(25)

267

self-regulation, especially where short-term solutions are most efficient and effective. The increasing market fragmentation is a side effect of facilitating competition and thus, any regulatory intervention will be a trade-off between the harms of fragmentation and the benefits of competition. The more regulators attempt to decrease fragmentation and to increase transparency, the more technical advancements are necessary to successfully compete in the market. As a result, more traders who cannot afford these advancements seek for alternatives to avoid the disadvantages of this tough competition. As long as there is a demand for dark trading, traders will try to satisfy this demand, presumably at all costs, trying to find a loophole in the regulatory framework. Therefore, regulators should combat the actual cause of the issues and reduce the incentives for dark trading. Excessive transparency, e. g. real-time disclosure of dark trading data, may increase front-running and drive investors, particularly institutional investors, off the market. Because these investors are important contributors to price discovery, their displacement could have an unintended detrimental impact on market efficiency and market quality. Regulators should consider the benefits dark trading provides to those investors and focus on minimizing the incentives and making trading in the lit sector more attractive for traders who mitigated to the dark sector. Efficient and effective regulation of dark trading therefore requires regulation of trading practices, in particular HFT. The major issue is that regulators have difficulty to detect and monitor predatory trading strategies, irrespective of whether they are pursued on a lit venue or dark venue. Rather than directly restricting dark trading and imposing rules that de facto eliminate dark pool trading, regulators should address HFT and predatory trading strategies. Moreover, they should encourage the interconnectedness between the dark sector and the lit sector and enhance surveillance of the trading venues and trading practices. Furthermore, given the current development of dark fragmentation and the noteworthy market share of dark trading, regulators should revise the calculation of trading volumes that are relevant for the listing in stock market indices. These indices are currently based exclusively on the amount of trading taking place on the public exchanges and do not consider the sometimes significant amount of trading taking place ‘off-exchange’ on dark venues. Overall, regulatory intervention should be simple and exceptional. The primary goal is to create a level playing field among the market participants within a free market economy. Therefore, legislators should set core princi-

268

Summary of the Final Conclusions

ples on an international, supranational and national level and design a regulatory framework (with a broader scope of application) but leave the specifications to the industry and market participants. Moreover, given the increasing globalization and cross-border activity in the securities markets, regulators should focus on international cooperation to prevent regulatory arbitrage and encourage supervision and enforcement.

https://doi.org/10.1515/9783110661873-009

Legal

Legal

Economic, empirical

US, EU

Gadinis () US, EU

US

N/A

US

O’Malley ()

Buti/ Rindi/ Werner ()

Buti/ Rindi/ Werner ()

O’Hara/ Ye ()

Economic, empirical

Economic, theoretical

Country Type

Author

Fragmentation and liquidity

Fragmentation and liquidity

Fragmentation and liquidity

Fragmentation and liquidity

Fragmentation and liquidity

Subject

Appendix – Literature Review

Positive impact on market quality and efficiency

Positive impact on market quality

Conclusion

A higher level of dark fragmentation results in Positive impact on market quality and effilower transactions costs, faster execution, ciency and better market quality. It facilitates competition in the US equity markets without degrading transactional or informational ef-

Dark pools generally have a positive effect on Positive impact on market quality if dark pool liquidity by tightening the spread for liquid activity remains below a certain threshold stocks and widening the spread for illiquid stocks. However, a higher level of dark pool activity may have a harmful impact.

Dark pools have a positive effect on liquidity Positive impact on market quality provision as they attract order flow from the limit order book. More dark pool activity is associated with narrower spreads, more depth, and lower volatility and thus, with better market quality.

Dark fragmentation provides benefits to the market including the reduction of trading costs and price improvement, thereby attracting order flow and increasing liquidity.

Dark fragmentation provides benefits to the market including the reduction of trading costs and price improvement, thereby attracting order flow and increasing liquidity.

Findings

Appendix – Literature Review

269

Fragmentation and liquidity

Fragmentation and liquidity

Economic, empirical

Degryse/ De EU Jong/ Van Kervel ()

Madhavan/ Canada Economic, Porter/ Weaver empirical ()

Fragmentation and liquidity

Economic, empirical

US

Preece/ Rosov (CFA Institute) ()

Subject

Country Type

Author

Continued Conclusion

Increase in transparency raises execution Positive impact on market quality due to lack costs and reduces liquidity leading to signif- of transparency icant declines in stock prices. This may support the conclusion that due to the lack of transparency, dark trading benefits the markets.

Increase in dark trading is associated with a Harmful impact on market quality reduction in global depth. Dark fragmentation does not only lead to a shift in liquidity from the lit market to the dark market but also harms overall spreads as more limit orders move to the dark market. Thus, dark trading negatively effects liquidity.

Dark fragmentation reduces indirect trading Positive impact on market quality if dark pool costs in form of lower bid-offer spreads and activity remains below a certain threshold higher depth and facilitates the minimization of information leakage and market impact.

ficiency. However, their sample uses data from both lit and dark venues and hence, does not further distinguish between the differential impact on liquidity of visible and dark fragmentation.

Findings

270 Appendix – Literature Review

N/A

US

Bloomfield/ O’Hara/ Saar ()

Hatheway, Kwan, Zheng ()

Apergis/ Volio- EU (UK) Economic, tis () empirical

Economic, empirical

Economic, theoretical

Country Type

Author

Continued Conclusion

Positive impact due to narrower spreads and By most measures, dark fragmentation affects liquidity and informational efficiency higher profits, neutral impact on liquidity and only slightly. Spreads in the dark sector are informational efficiency narrower and informed traders make higher profits by dark trading. Within the context of a single market, trader strategies change with the market structure so that outcomes need not be uniquely determined by market rules.

Findings

Fragmentation Dark trading leads a segmentation of traders Harmful impact on liquidity, but positive imand liquidity as informed traders typically face relatively pact on price discovery Price discovery low execution probabilities in dark pools and thus, stay in the lit markets, whereas more uninformed traders choose to trade in dark markets. This causes a migration of liquidity and an increase in adverse selection costs. However, the dissemination of information also leads to improved prices.

Fragmentation Dark fragmentation is associated with higher Harmful impact on liquidity and price disand liquidity transaction costs and lower price efficiency. covery, overall negative impact on market Price discovery Dark trading attracts uninformed traders who quality do not contribute to price discovery, while informed traders remain in the lit sector. This causes an increase in adverse selection costs and disincentivizes liquidity providers to compete for order flow harming liquidity.

Fragmentation and liquidity

Subject

Appendix – Literature Review

271

N/A

N/A

Zhu ()

Ye ()

Economic, theoretical

Economic, theoretical

Country Type

Author

Continued Findings

Conclusion

Price discovery Model is based on free venue selection only Harmful impact but self-mechanism will limit by informed traders acting as a monopolist. the impact Informed traders usually have a higher incentive to trade in the dark in order to hide their information, thereby increasing liquidity in the dark. Thus, adding a dark pool thus harms price discovery if and when an informed trader can trade in the dark pool. However, because informed trading in dark pools causes lower execution probability and decreases its competitiveness it is in the dark pool’s own best interest to limit the impact of informed traders by, for example, changing its allocation rules.

Price discovery Model is based on strategic venue selection Positive impact under natural conditions by informed traders and uninformed liquidity traders. Differences in execution risk between lit venues and dark venues cause segmentation of traders: more informed traders in lit market, more uninformed in dark market, leading to higher adverse selection risk, change in liquidity, improving price discovery. The introduction of dark pools improves price discovery since informed traders choose to trade on the lit markets minimizing the risk of execution (self-selection process).

Subject

272 Appendix – Literature Review

Economic, empirical

US

EU

Ready ()

Buchanan/ Tse/ Vincent/ Lin/ Kumar ()

Findings

Conclusion

Price Discovery In an environment where traders can freely Positive impact (consistent with Zhu) select, informed traders less likely send their orders to the dark, supporting the selectionprocess as predicted by Zhu.

Price discovery Dark trading leads to partial segmentation of Positive impact but harmful when exceeding informed and uninformed traders with less  % of dollar volume in stock (consistent informed trades executed in the dark corre- with Zhu regarding segmentation of traders) lated with the level of execution risk and adverse selection risk. However, reduction in uninformed traders in the lit sector reduces incentives for information acquisition, leading to a decrease in information production which may ultimately harm price discovery. Thus, high levels of dark trading, exceeding ten percent of the dollar volume in a given stock, harm informational efficiency and price discovery. Not all dark trading has the same effects on price discovery; differences between large block trades executed as dark orders (on an exchange) and other dark trades executed in dark pools.

Subject

Economic, Price Discovery There is no evidence that dark trading causes Positive impact on market quality theoretical significant differences in the price discovery, (statistical) and thus, dark trading does not harm the

Economic, empirical

Country Type

ComertonUS, Forde/ Putniņš AUS ()

Author

Continued

Appendix – Literature Review

273

US

US

US

Nimalendran/ Ray ()

Boni/ Brown/ Leach ()

Hintz ()

Legal

Economic, empirical

Economic, empirical

Country Type

Author

Continued Conclusion

Informed traders use both dark venues and Positive impact on market quality due to public exchanges to trade strategically. As a contribution to price discovery consequence, the information in dark venues is likely leaked to the public. Due to the relatively speedy dissemination of information from dark venues to the public exchanges, the impact of dark trading on price discovery is rather insignificant.

price discovery process but improves market quality.

Findings

Information leakage

The two largest weaknesses of dark pools are Harmful impact that requires regulatory ininformation leakage and front-running. More tervention regulatory intervention is necessary to address those issues and prevent further harmful impact.

Access restric- Dark pool exclusivity matters in regard to Positive impact on market quality in case of tions market quality. Dark pools specifically dedark pools designed to foster buy-side exsigned to foster buy-side exclusivity provide clusivity higher overall execution quality for large trades, typically executed by institutional investors. However, not all dark pools are created equal, results therefore may differ depending on the specific access rules of a dark pool.

Price discovery, information leakage

Subject

274 Appendix – Literature Review

N/A

Brunnermeier/ Pedersen ()

Economic, theoretical

EU (UK) Economic, empirical

Financial Conduct Authority ()

Legal

Country Type

Macey/ O’Hara US ()

Author

Continued

HFT and market integrity

HFT and market integrity

Information leakage

Subject

Harmful impact if dark venues execute orders at prices inferior to other prices available on the lit venues, so that HFT traders can benefit from latency arbitrage at costs of other participants.

No harmful impact due to dark pool exclusivity, impact due to restricted access to information does not per se justify regulatory intervention

Conclusion

Predatory trading leads to “price overshoot- Harmful impact on market stability if dark ing” and amplifies liquidation cost of other trading facilitates predatory trading strattraders. Predatory trading practices enhance

High-frequency traders make profits by using aggressive market orders at the expense of other participants. Detrimental effects are caused, if dark venues use stale reference prices that do not match the current midpoint of the NBBO/BBO at the public exchange, use prices inferior to other prices available. Consequently, high-frequency traders can benefit due to latency arbitrage by taking advantage of the price difference between dark and lit venues at this time.

Distinctions have to be made between access to trading opportunities and access to information. Access to trading opportunities is generally provided to the public by the exchanges and does not require access to dark pools. Therefore, the issue over access is about access to information that is valuable to the public. However, there is no general legal right or public policy justification for giving counterparties access to the valuable information contained in proprietary order flow and quotation information.

Findings

Appendix – Literature Review

275

EU

US, EU

N/A

Gomber/ Arndt/ Lutat/ Uhle ()

Prewitt ()

Lerch ()

Legal

Legal

Economic, empirical

Country Type

Author

Continued

HFT and market integrity

HFT and market integrity

HFT and market integrity

Subject

Conclusion

Algorithmic trading in general can impose Harmful impact on market stability and insystemic risks and have a harmful impact on tegrity the functioning of the financial markets as demonstrated by the flash crash in  and similar events.

HFT adds to systemic risk by tightly interHarmful impact on market stability, despite linking markets and creating the possibility some insignificant positive effects of Flash Crash-type events. HFT also provides opportunities for illegal market manipulation that are difficult and expensive to detect. On the positive side, HFT provides liquidity and narrows spreads under normal trading conditions, and its marketable orders tend to move prices in the right direction. Accordingly, however, empirical research has not demonstrated that these benefits are substantial.

HFT decreases volatility in the short-term and Positive impact on market quality enhances market liquidity, thereby increasing market efficiency and market quality

systemic risk and due to the interconnected- egies that enhance systemic risk; detrimental ness of modern markets disruptions in one effects on trading costs of other participants venue or market may spill over and trigger a crisis for the whole financial sector.

Findings

276 Appendix – Literature Review

N/A

Fleckner ()

Legal

Country Type

Author

Continued

HFT and market integrity

Subject

Conclusion

Harmful impact on market stability and inAlgorithmic trading in general can impose systemic risks and have a harmful impact on tegrity the functioning of the financial markets as demonstrated by the flash crash in  and similar events. Moreover, price manipulation can have far reaching consequences as prices are used for accounting and tax purposes

Findings

Appendix – Literature Review

277

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Index Access rules 97 et seqq., 101, 137 – 139, 204 – Access Rule (Rule 610) 138 et seq. – Discretionary access rules 97 et seq., 124, 126 – Fair access rule 22, 40, 134 et seq., 144 – Non-discretionary rules 11, 14, 180, 202, 204 et seq.Adverse selection costs see Costs Adverse selection risk 79, 81, 93, 115, 262, 272 et seqq. Agency broker operated see Types of dark pools Algorithmic trading 28 et seqq., 113, 191, 222 – 227, 246 et seqq. Alternative trading system see ATS ATS 13 et seqq., 40, 124, 132 et seq., 237 Amended Market Data Rules 137, 140 APA 17, 217, 220 Approved Publication Arrangements see APA Arbitrage 32, 44, 87, 106 – 108 Arbitrage strategies see High-frequency trading techniques Asymmetries – Asymmetries among market participants 64, 97 et seqq. – Informational asymmetries 19, 66, 94 – 97, 100, 116, 122, 150 et seqq., 211, 239, 258 – Regulatory asymmetry 236 Automated trading 1, 21, 28, 48, 101, 137, 222 – 226 Bid-ask spread 32, 41, 79, 86, 91 Bid-offer spread 91, 108, 270 Block order see Block trades Block trades see Order types Broker-crossing networks 228 Broker-dealer Internalization 22 Broker-dealer operated see Types of dark pools BTS 17, 195

https://doi.org/10.1515/9783110661873-011

CFTC 17, 101 Co-location services 30, 44, 107, 110, 143, 224 et seq., 234 Concentration rule 43, 179 Consolidated quotation data 14, 17 et seq., 23, 107 Consolidated Quotation System 9, 14, 19, 131 Consolidated Tape Association 9, 17, 147 Consolidated Tape Provider see CTP Consolidation 9, 19, 74, 78, 124, 140, 172, 181, 185, 191, 199, 218 – 221, 240, 245 et seqq., 248 Costs – Adverse selection costs 92 et seq., 96, 271 – Implicit costs 57 – Market impact costs 28, 46 et seq., 50, 85 et seq., 116, 239 – Trading costs 2, 18, 27, 36, 46, 57, 65 et seq., 84 – 86, 90 – 93, 95, 104, 115, 149, 239, 251, 253 – Transaction costs 47 et seq., 50, 90 f., 93, 108, 184, 218 CTP 9, 17, 217, 219 – 220 Customer order see Order types Dark order see Order types Dark pool 1 – 3, 14, 17 et seqq., 20 et seqq., 46 et seqq., 50, 66, 73 et seqq., 95, 124, 144 et seq., 171, 228 et seqq. Dark trading 1 et seq., 6 – 10, 16 et seq. Dark venue 7 et seqq., 18, 48, 98, 110 et seqq. Decimalization 40 Decimal pricing 41 Deterioration of prices 82, 93 Directional strategies see High-frequency trading techniques Discretion 23, 131, 149, 159, 167, 174, 190, 198, 201 – 206, 209, 215, 224, 235 Discretionary access rules see Access rules

Index

Double volume cap mechanism 199, 218, 230 – 233, 243, 251 Double volume caps 216, 218, 230, 233, 243, 248 et seq., 259 Draft binding technical standards see BTS EBBO 17 – 19, 74, 183 ECN 14 et seqq., 27, 39 – 41 Electronic communication network see ECN Electronic front running see Front running Electronic market maker operated see Types of dark pools ESMA 177, 188, 194 et seqq., 204, 209 et seq., 218, 247 European national best bid and offer see EBBO Execution priority 41, 253 Execution probability 48, 66, 79 et seq., 85, 105, 272 Execution risk 79, 81, 117, 272 et seq. Fair access rule see Access rules FCA 1, 8, 10, 18 – 20, 48, 75, 112, 116, 200, 208, 213, 275 Financial Conduct Authority see FCA Financial crisis 2, 52, 60, 63, 121, 176, 186 et seq., 190, 222 Financial Industry Regulatory Authority see FINRA FINRA 128 et seq., 154 et seqq. 245 Flash Crash 34 et seqq., 51, 101, 113, 222 Flash trading see High-frequency trading techniques Form ATS-N 150 Free riding 41 Free-riding 70, 75, 77 Front running see High-frequency trading techniques Globalization

26, 44 et seqq., 49, 122, 240

Harmonization 174, 176 et seq., 190, 193, 209 HFT 26, 29 et seqq., 34, 36 et seqq., 47, 102, 105 et seqq., 222 et seqq., 234 et seqq., 246 et seqq., 255 et seqq. Hidden order see Order types

295

High-frequency trading see HFT High-frequency trading techniques 47, 223 – Arbitrage strategies 33, 87, 106 – Directional strategies 33 – Flash trading 107 – Front running 143, 161 – Latency arbitrage 106, 112, 168 et seq., 227, 253, 275 – Layering 105, 109, 226 – Market making strategies 32 – Momentum ignition 109, 226 – Pinging 87, 106, 226 – Quote stuffing 105, 108, 226 – Spoofing 109, 162, 226 Iceberg order see Order types Implementing technical standards see ITS Implicit costs see Costs Indication of Interest 18, 87, 97, 145 – 147, 165, 211 Informational asymmetries see Asymmetries Information leakage 43, 47 et seq., 50, 92, 110, 116, 148, 153, 163, 173, 239, 274 Informed order see Order types Informed traders 70, 76, 78 – 82, 91, 93, 115, 254, 262, 271 – 274 In-house matching 23 Internalization 16, 22 – 24, 49, 131, 148 et seq., 159, 179, 244 – Systematic Internalization 22, 24, 180, 184, 199, 206 et seqq., 209, 211, 228 et seq., 244 International Organization of Securities Commission see IOSCO In the Matter of Barclays Capital 167 et seqq. In the Matter of Credit Suisse 166 et seqq. In the Matter of Deutsche Bank 169 et seqq. In the Matter of eBX 162 et seqq. In the Matter of ITG 165 et seqq. In the Matter of Liquidnet 163 et seqq. In the Matter of Pipeline Trading 160 et seqq. In the Matter of UBS 164 et seqq.

296

Index

Investor protection 11, 23, 42, 52, 60 – 62, 65, 95, 99 et seq., 105, 112, 114, 116, 122, 151, 155 et seq., 176, 180, 186, 190, 211, 242, 250 et seq., 253, 255 IOI 87, 94, 97, 100, 145 – 147, 211, 244, 248 IOSCO 20, 61, 66, 71, 90, 95, 97, 100, 122, 199 ITS 177, 189, 194 – 196 Lack of transparency see Transparency Lamfalussy II process 188, 195, 249 Lamfalussy process 177, 188, 237 Large-in-scale order see Order types Large-in-scale waiver see Transparency waivers Latency 29 – 31, 36, 108, 227 Latency arbitrage see Electronic front-running Layering see High-frequency trading techniques Level 1 acts 188 Level 2 acts 188 – 190 Level 3 acts 188 Limit order see Order types Liquidity 8, 10, 17, 23, 25, 34, 48, 62, 65 et seq., 80 et seqq., 85 et seqq., 91 et seqq., 96, 104 et seq., 113, 115, 201, 204, 213, 250, 255 Liquidity provider 16, 32, 42, 47, 57, 105, 110, 164, 229, 235, 250, 255 Lit trading 7 et seq. Lit venue 5, 8 et seqq., 10 – 16, 21, 46, 57, 65, 75 et seq. Manipulation see Market manipulation Market depth 81, 136 Market efficiency 61 et seqq., 67, 86, 95, 190, 211, 239, 246, 253 – 255 Market failure 59, 64, 85, 100, 174, 241, 243, 248 – 250, 257, 262 Market fragmentation 5, 65 et seq., 83 et seqq., 94, 104, 106, 117, 131, 136 et seqq., 186, 250 Market impact costs see Costs Market integrity 62 et seqq., 65, 67, 95, 99, 112, 114, 116, 155, 239, 249, 275 – 277

Market maker 20 et seq., 27, 39, 49, 85, 104 et seq., 132, 134, 148, 165, 210 Market making strategies see High-frequency trading techniques Market manipulation 102, 107, 110, 113 et seq., 118, 160, 222 et seq., 226 et seq., 276 Market order see Order types Market quality 62 et seqq., 81 et seqq., 90 – 93, 99, 113, 115 – 117, 127, 173, 229, 234, 242, 246, 248, 254, 273, 276 Market stability 63 et seqq., 101, 103, 105, 113, 176, 222, 227, 248, 255, 275 – 277 Matched principal trading 201 et seq., 204 – 206, 216, 228 May 6th Flash Crash see Flash Crash MiFID I 9, 12, 15, 24, 42 et seq., 74, 176, 178 et seqq., 184 et seqq., 187, 203, 212, 215, 258 MiFID II/MiFIR 9, 15, 19, 24 et seq., 74, 176, 186 et seqq., 192 et seqq., 199 et seqq., 227 et seqq., 257 et seqq. Momentum ignition see High-frequency trading techniques Monopoly 9, 43, 58 et seq., 122, 131, 219 MTF 14 – 16, 19, 26, 43, 99, 180 – 182, 197, 202, 205 et seqq., 228 Multilateral trading facility see MTF National best bid and offer see NBBO NBBO 9, 14, 19, 39, 74, 90, 112, 126, 134, 136, 141, 145, 148 et seq., 244 Negotiated-price waiver 44 Non-block order see Order types Non-discretionary rules see Access rules Off-exchange trading see OTC Order book 11, 17, 34, 43, 47, 65, 71, 75, 85, 181, 210, 232 et seq. Order driven see Trading systems Order Handling Information 144, 152 f. Order Handling Rules 38 et seq., 134 Order Protection Rule 24, 41, 137, 141 Organized Trading Facility see OTF Order types – Block trades 45 – 47, 74, 81 et seq., 126 et seq., 182 – 184, 231, 273

Index

– Customer order 21, 124, 152 et seqq., 161 et seq. – Dark order 16 et seq., 49, 66, 74 et seq., 78, 81, 123, 126, 183 – Hidden order 7, 16 et seq., 36, 87, 110, 233 – Iceberg order 17, 183, 212 – Informed order 79 – Large-in-scale order 74, 183 – Limit order 11, 13, 32, 39, 41 et seq., 46 et seq., 68, 85 et seq., 92, 109, 137 – 140, 152 – Market order 11, 46 et. seq., 108, 112, 152 – Non-block order 143 – Uninformed order 79 OTC 1, 3, 5, 17, 21 et seq., 25, 43, 49, 56, 92, 125, 147 et seq., 150, 156, 180 – 186, 191, 201, 206 – 209, 220, 227 et seqq. OTF 19, 191, 199 – 202, 201 – 206, 208, 2010, 217, 220, 224, 228, 241, 244 et seqq. Over-the-counter see OTC Perfect competition 58 Pinging see High-frequency trading techniques Post-trade data 9, 73, 124, 181 et seq., 219, 221, 245 et seq., 254 Post-trade transparency see Transparency Predatory pricing 59 Predatory trading 4, 32, 37 et seq., 57, 66 et seq., 101 et seqq., 105 et seqq., 110 – 118, 162, 168 et seq., 173, 239, 246 et seqq., 251 – 253, 275 et seq. Pre-trade data 73, 78, 82, 103, 181 et seq., 212, 221, 229, 254 Pre-trade transparency see Transparency Pre-trade transparency waivers see Transparency waivers Price determination 20 – 22, 46, 71, 75 Price discovery 8, 10, 12 et seq., 19, 22, 46, 49, 65, 67 et seqq., 71 et seqq., 75 – 82, 95, 99, 115, 123, 201, 208, 216, 228, 243 et seqq., 254 et seq. Price discovery process 3, 12 et seq., 15, 19, 65 – 67, 69, 71 – 73, 75 – 78, 82, 255 Price formation 15, 71 et seqq., 79, 95, 175

297

Price impact 10, 74, 149 Price improvement 24, 48, 79, 90, 126 et seq., 139, 143 et seq., 149, 269 Price production 70 Primary exchanges 43, 49, 83 Priority 71, 94, 126, 150, 183, 234 Priority rules 136 Probability of execution 46 Program Trading 27 Proprietary capital 185, 204 et seq., 244 Proprietary trading 30, 151, 201 et seq., 206, 223 Proprietary trading desk 161, 166 Public Securities Exchanges 11 et seq., 25 Public trading venues 141 Quotation 42, 44, 101, 137 – 141, 146 – 147, 244 et seq. Quote 8, 23 et seq., 39, 72, 74 et seq., 90, 126, 132, 139, 182, 211, 242, 245 Quote driven see Trading systems Quote Rule 40, 134 Quote stuffing see High-frequency trading techniques Reference price 19, 22, 46 et seq., 49, 109, 112, 208, 212 et seq. Reference price mechanism 72, 77, 85, 90 Reference-price waiver see Transparency waivers Reference pricing 75 et seq. Regulated Markets see RM Regulation ATS 38, 40 et seq., 98, 130 – 134, 144, 147, 156, 172 Regulation NMS 38, 41 et seq., 130, 136 – 142, 147, 152, 172, 244, 259 Regulatory arbitrage 16, 121, 159, 184, 187, 194, 199, 201 et seq., 206, 208, 227 et seq., 235, 240 – 242, 247, 256 Regulatory asymmetry see Asymmetries Regulatory technical standards see RTS Risk-benefit analysis 113 Risk of no execution 79 RM 11, 15, 74, 98, 180 – 183, 186, 189, 191, 197, 203, 206

298

Index

RTS

20, 177, 188, 194 – 196, 204, 208, 210 – 217, 219 et seq., 225, 230, 257 Ruinous competition 59 SEC

8, 39 et seq., 54, 101, 128 – 155, 157, 160 – 173, 194, 247, 250 Securities Exchange Commission see SEC Securities Exchanges see Public Securities Exchanges Securities Information Processor see SIP Security’s price 64, 68 – 70, 76, 109 Segmentation – Segmentation of orders 79, 93 – Segmentation of traders 79, 82, 93, 95, 115, 117, 262, 271 – 273 Self-regulatory organization see SRO Self-selection process 79, 272 SIP 9, 20, 140 – 143, 168 – 169, 172 Spoofing see High-frequency trading techniques SRO 20, 74, 119, 125, 128, 133 et seqq., 139 – 141, 147, 154 et seq., 247, 250, 256 Standards for Alternative Trading Systems 175 Stock market indices 66 et seq., 83 et seq., 88, 115 Sub-Penny Rule 137, 139 et seq. Supervision 110, 114, 116, 121, 123, 173, 177, 189 et seq., 194, 197, 222, 228, 236, 239, 247 et seq., 249, 259 Systematic Internalization see Internalization The 1975 Act Amendments 38 et seq. Threshold 40, 66, 73 et seq., 81 et seq., 89, 91 – 94, 98, 115, 117, 124 et seq., 131, 134, 144 et seq., 147, 156, 172 et seq., 207, 217, 230, 232, 240 – 244, 248 et seq., 259, 269 et seq. Tick Size 149, 225, 229 Tick Size Pilot 148 et seq. Trade-at Rule 126 – 127, 130, 144, 148 – 150 Trade-through Rule 41, 137 Trading costs see Costs

Trading fees 21, 47 Trading obligation 199, 208 et seq., 244 Trading systems – Order driven 71, 85 – Quote driven 210 Transaction costs see Costs Transparency 1, 5, 8, 42 et seq., 50, 62, 67, 71 – 74, 93, 111, 116, 122 – 125, 127, 130, 134, 140 et seq., 145, 150 et seq., 153, 155 – 157, 172, 175, 181, 191, 199, 207, 209 – 217, 220, 229 et seq., 236, 242 – 244, 248, 253 et seq. – Lack of transparency 4, 67 et seqq., 72 et seqq., 78, 93, 110, 112, 115 et seq., 150, 160, 185, 251, 253 et seq. – Post-trade transparency 9, 12, 15, 18, 43, 54, 72 – 75, 123 – 125, 140, 144, 180, 182, 210, 215 et seq., 219 – Pre-trade transparency 9, 12, 15 et seq., 18, 43, 47, 57, 70, 72 – 75, 78, 82, 95, 110, 115, 123, 125 – 127, 182, 184 et seq., 196, 210 et seqq., 219, 228 et seq., 242, 245, 254 Transparency waivers 195, 209 et seqq. – Large-in-scale waiver 43, 212, 218, 232 – Pre-trade transparency waivers 196, 198, 212 et seqq., 237 – Reference-price waiver 44, 183, 208, 212 et seq., 216 et seq., 231 et seq. Types of Dark Pools – Agency broker operated 21 – Broker-dealer operated 22, 127 – Electronic market maker operated 21 Uninformed order see Order types Uninformed traders 56, 79, 81 et seq., 93, 115, 271, 273 US Commodity Futures Trading Commission see CFTC Volatility 34, 36, 62, 79, 85, 91, 102, 113, 116, 269, 276 Volume caps see Double volume caps Volume-weighted spread 74, 183, 216