Soon to be published in The Journal of Financial Economics, the paper says that dark pools, by allowing some traders to circumvent time priority, create a queue-jumping advantage that has facilitated their rapid growth at the expense of lit venues.

Author Amy Kwan, CMCRC PhD, said the paper raises concerns that policy settings in the US are inadvertently supporting dark trading over lit. Limit orders submitted to dark venues can execute ahead of displayed orders on lit exchanges as long as the price is at or within the NBBO. This drags liquidity away, reducing depth and increasing spreads on lit markets.

The study looked at market depth, particularly around the $1 price level. RegNMS rules mean that when stock drops below $1, minimum pricing increments fall from $0.01 to $0.0001. this means there are strong incentives for traders to migrate their order flow to dark venues to benefit from 'queue jumping' when stocks are trading just above $1. This incentive is lost when the price falls below the $1 threshold.

"Our study found a sharp rise in dark venue market share when stock prices are just above the $1 level," Kwan said. "The effect isn't constrained to penny stocks - high priced stocks exhibit similar behaviours. We also see that on trading days when stocks are severely constrained by the minimum pricing increment, dark venues gain market share as well."

"The study lends support to the introduction of a 'trade at' rule, as is currently being debated by the SEC," she says. "Requiring dark orders to be routed to lit exchanges unless dark pools can provide meaningful price improvement would support depth and tighten spreads on the lit markets which in turn is positive for price discovery, which, after all, is what markets were designed for originally."