Dark Trading at the Midpoint: Pricing Rules, Order Flow and High Frequency Liquidity Provision

We examine the competitive advantage enjoyed by dark venues over stock exchanges due to rules regulating the minimum price variation (MPV) for quoting equity securities. The MPV rule requires quotes above $1.00 per share to be in pennies, but it permits subpenny trades to facilitate price improvement for marketable orders. This exception to the penny quote rule benefits dark venues by allowing broker-dealers to intercept market orders by offering subpenny trading opportunities. However, a growing chorus of critics allege that (a) dark venues exploit this exception by offering little or no price improvement for market orders, and (b) allowing dark venues to intercept market orders harms the incentive to display liquidity on exchanges on which markets depend for efficient securities pricing. Using a novel regression discontinuity design and over eight trillion observations on market data from 2011-2014, we provide evidence that is inconsistent with both critiques. First, increasing the incentive to use the exception to the penny quote rule increases the rate of trading in dark venues at the midpoint of the national best bid and offer, thus offering liquidity takers price improvement in the form of the quoted half-spread. Second, while enhanced order flow to dark pools decreases price competition on exchanges, this reduction is primarily because of reduced quoting among high frequency trading (HFT) firms. Consistent with concerns about HFT, we show HFT market-making increases price volatility and that overall trading volume increases when it occurs in dark pools rather than on exchanges.