Journal of Law, Finance, and Accounting > Vol 4 > Issue 2

Dark Trading at the Midpoint: Does SEC Enforcement Policy Encourage Direct Feed Arbitrage?

Robert P. Bartlett, III, University of California, Berkeley, USA, rbartlett@berkeley.edu , Justin McCrary, University of California, Berkeley and Columbia University, USA, jrm54@columbia.edu
 
Suggested Citation
Robert P. Bartlett, III and Justin McCrary (2019), "Dark Trading at the Midpoint: Does SEC Enforcement Policy Encourage Direct Feed Arbitrage?", Journal of Law, Finance, and Accounting: Vol. 4: No. 2, pp 291-342. http://dx.doi.org/10.1561/108.00000039

Publication Date: 13 Dec 2019
© 2019 R. P. Bartlett and J. McCrary
 
Subjects
 
Keywords
JEL Codes: G10, G15, G18, G23, G28, K22
Latency arbitragehigh-frequency tradingdark poolstick sizesmarket structure
 

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In this article:
1. Introduction 
2. Institutional Details 
3. Dark Trading and the MPV 
4. Midpoint Trading and Direct Feed Arbitrage 
5. Conclusion 
Appendix A: Delisting and Price Clustering Concerns 
Appendix B: Midpoint Trading with Maker-Taker Pricing Controls 
References 

Abstract

Prevailing research in market microstructure posits that liquidity providers bypass queue lines on exchanges by offering liquidity in dark venues with de minimis sub-penny price improvement, thus exploiting an exception to the penny quote rule. We show that (a) the SEC enforces the quote rule to prevent sub-penny queuejumping in dark pools unless trades are “pegged” to the NBBO midpoint and (b) the documented increase in dark trading due to investor queue-jumping stems from increased midpoint trading. Although encouraging pegged midpoint orders can subject traders to direct feed arbitrage, we estimate that less than 2% of shares traded per year present exploitable trading opportunities for this form of latency arbitrage, yielding annual gross potential profits of less than $20 million.

DOI:10.1561/108.00000039