Be careful what you wish for. As the Fed imbibes a sense of confidence in its ability to manage any bumps in the road on its perpetual bubble-blowing mission through the use of macro-prudential policies (big words that truly mean nothing) as stock valuations surge and the repo market is experiencing severe problems; it can always point to VIX as an indicator that all is well in the world and no real risk exists. The problem is - the world is beginning to wake up to the 'odd' micro-structure of the US equity markets and how 'dark pools' are beginning to dominate trading volume. As Barclays faces major legal problems over its alleged dark pool lies, lies, and more lies, the Fed must be growing concerned... as the following chart shows JPMorgan indicates there is evidence of an inverse relationship between equity volatility and the share of off-exchange trading.
Off-Exchange trading has soared since the financial crisis...
Off exchange trading rose sharply in 2009 with volumes almost doubling vs. 2008. But off-exchange volumes declined since then for three consecutive years i.e. during 2010, 2011 and 2012. The average daily volume of off-exchange share transactions rose in both 2013 (+6.4%) and in 2014 (+6.1%). This compares to -8.9% YoY change in exchange trading volumes in 2013 and +3.3% in 2014 YTD. That is off-exchange trading has grown much faster than exchange trading over the past two years. As a result the share of off-exchange volumes as percentage of total equity trading volumes jumped in 2014 to 37%, the highest ever (Figure 2).
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YTD 2.4bn shares per day were traded off-exchange vs. 4.1bn shares per day in traditional exchanges. For comparison, in 2008 2.1bn shares per day were traded off exchange vs. 7.7bn on exchanges. But, we note that the improvement in off exchange volumes over the past two years does little to alter a picture of still subdued overall equity trading volumes.
With dark pools dominating...
As mentioned above dark pools or ATS represent only a part of off-exchange trading and reporting has started only recently in May 2014. For the two weeks commencing May 19th and May26th FINRA reported an ATS trading volume of 0.78bn shares per day which accounted for 39% of off-exchange (TRF) volumes for these two weeks and 15% of all trading volumes (on and off exchange) for that week also. That is, dark pools or ATS account for around 39% of off-exchange trading activity and 15% of all equity trading volumes.
But there is a relationship between stock volatility and off-exchange trading...
We find evidence of an inverse relationship between equity volatility and the share of off-exchange trading.
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This is shown in Figure 3 which suggests that big drops in equity volatility in the past were associated with shifts towards off exchange trading. One potential explanation is that price competition intensifies when volatility goes down, as overall volumes also decline, causing a shift in equity trading towards lower cost off-exchange venues.
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Simply put - the end of dark pools would be the end of the complacent benign risk markets that the Fed enjoys control over...
