Department of Accounting and

Finance

MSc Finance

AG912 International Financial Markets and Banking

Lecturer: Juliane Thamm

‘Should dark pools be prohibited?’

Discuss this statement by exclusively presenting arguments that this is
not the case.

KARAKAISIS NIKOLAΟS
Registration Number: 201794685

6th of November 2017

A dark pool has been defined by Pan (2017) as an electronic trading platform in which buyers and sellers
are automatically matched for trading securities; in such platforms, the trading information of those market
participants is not being disclosed (Garvey, Huang and Wu, 2016).

The purpose of this essay is to present the main reasons why dark pools should not be prohibited by adopting
two main perspectives, that of the market and of the institutional investor, each of which will be thoroughly
explained. More specifically, the analysis will begin with how dark pools contribute to an improved market
quality by affecting the liquidity, price impact and price discovery, before explaining how dark pools act in
the interest of institutional investors by focusing on transaction costs, price improvement and information
transparency.

In the first place, dark pools beneficially affect the market. More explicitly, Aquilina et al. (2017) believe
that, with dark pools, a higher standard of the market is being achieved. As a matter of fact, high activity in
dark pools results in an improved market quality (Buti, Rindi and Werner, 2011). The above can be
supported by Cheridito and Sepin (2014) who claim that dark pools increase liquidity in the market, unlikely
with lit venues and, therefore, it has a positive impact on the market. The same authors further explain that,
if the orders were to be sent to the market completely displayed, as far as liquidity is concerned, it would
have been detrimental for the market; so dark pools are preferred in such case. Moreover, He and Lepone
(2014) suggest that dark trading volume not only is negatively associated with market imbalance but, also,
prevents uncertainty in the market. What is more, it has been largely supported in literature that the orders
in a dark market are executed with lower costs than the ones in a lit market (Garvey, Huang and Wu, 2016;
Conrad, Johnson and Wahal, 2002). Hence, drawing upon Cohen et al.’s (1981) research who emphasized
that reduced transaction costs generate larger order flow, it can be inferred that dark pools are advantageous
for the market as they contribute to greater flows and, thus, liquidity. Another market-related variable that
is positively affected by dark pools is that of the price impact. Zhu (2014) underlines that the larger the
orders placed in a dark pool are, the greater the impact of the price on the market is. Furthermore, in a dark
pool, after buyers and sellers are being matched, the execution price of the orders is the up-to-date demand
and supply spread on an exchange market. This results in not having any impact cost on the market since
the price is stabilised for the entire volume (Petrescu and Wedow, 2017) and, as a consequence, it does not
affect the liquidity. As Petrescu and Wedow (2017) further state, this pattern indicates a better price
compared to market orders and shows how far the market price will be moved, which, in turn, favors dark
trading. At this point, it is worth mentioning that dark pools improve price discovery. Regarding this, Zhu
(2014) has created a model that concludes to the fact that price discovery is greater in dark pools under
certain circumstances, provided that adequate information is being revealed. Similarly, the model of Ye
(2016) illustrates that, in dark trading, price discovery is enhanced; however, that depends significantly on
how much information is being displayed. Hence, with all the aforementioned reasons considered, I strongly
believe that dark pools should be allowed.

Besides their positive effects on the quality of market, I would suggest that dark pools are considerably
beneficial for an institutional investor as well. Primarily, He and Lepone (2014) state that the foremost
advantage of dark pools, from an institutional investor’s standpoint, is the reduced transaction cost and it
appears that Conrad, Johnson and Wahal (2002), in their research on dark pools, had concluded to the same;
a dark pool has lower execution costs than the traditional market. Likewise, Buti, Rindi and Werner (2011)
find that, if an order was to be displayed in the traditional market, noteworthy commission costs would
have been generated. In this occasion, the institutional investor would most likely prefer a dark pool.
Another crucial factor that renders dark pools vital for an institutional investor is better price. Studies reveal
that, in dark venues, 4 out of 5 times, the price is improved than the price in lit venues (Garvey, Huang and
Wu, 2016). Complementing on that, Buti, Rindi and Werner (2011) highlighted that the effective spreads
are lower when the dark pool activity is high. In addition, as it was briefly mentioned before, information
does, also, play a substantial role when it comes to trading venues, dark or lit. More specifically, in dark
pools, low levels of pre-trade transparency are observed and, in many cases, there is no transparency at all
(Buti, Rindi and Werner, 2011). This phenomenon leads to minimising the possibility of information of an
order being publicized (Pan, 2017). Therefore, dark pools are favorable for investors who do not want their
information to be displayed; so, the information leakage is limited in these venues (Petrescu and Wedow,
2017). By limiting the information leakage, the intentions of the investors are not being exposed to the
market and this results in the prevention of investors being front-run (Zhu, 2014). Furthermore, it is
important to notice that the institutional investor wants to avoid the counterparty risk which is the risk of
being front-run by broker-dealers and other market participants (Buti, Rindi and Werner, 2011).
Consequently, the transaction costs for the institutional investor will be increased. Hence, it is clear enough
that, as a large part of the academic literature suggests, the institutional investor can be protected by the use
of dark pools since they do not reveal the trading interest to the public. Therefore, taking all the above in
consideration, I believe that dark pools are necessary for an institutional investor as well.

To recapitulate, through an examination of the current academic literature, it is my firm belief that dark
pools should not be prohibited.

Word Count: 1011

REFERENCES

Aquilina, M., Diaz-Rainey, I., Ibikunle, G. and Sun, Y. (2017) Aggregate Market Quality Implications of
Dark Trading, FCA Occasional Paper No. 29. Available at: https://ssrn.com/abstract=2824352

Buti, S., Rindi, B. and Werner, I.M. (2017) ‘Dark pool trading strategies, market quality and welfare’.
Journal of Financial Economics, 124 (2), pp.244-265.

Cheridito, P. and Sepin, T. (2014) Optimal trade execution with a dark pool and adverse selection,
Working Paper. Princeton University. Available at: https://ssrn.com/abstract=2490234

Cohen, K.J., Maier, S.F., Schwartz, R.A. and Whitcomb, D.K. (1981) ‘Transaction costs, order placement
strategy, and existence of the bid-ask spread’. Journal of Political Economy, 89 (2), pp.287-305.

Conrad, J., Johnson, K.M. and Wahal, S. (2003) ‘Institutional trading and alternative trading
systems’. Journal of Financial Economics, 70 (1), pp.99-134.

Garvey, R., Huang, T. and Wu, F. (2016) ‘Why do traders choose dark markets?’. Journal of Banking
& Finance, 68, pp.12-28.

He, W.P. and Lepone, A. (2014) ‘Determinants of liquidity and execution probability in exchange
operated dark pool: Evidence from the Australian Securities Exchange’. Pacific-Basin Finance
Journal, 30, pp.1-16.

Pan, J. (2017) Does Dark Trading Affect the Link between Stock Prices and Fundamentals?, Working
Paper. University of Utah - David Eccles School of Business. Available at:
https://ssrn.com/abstract=2981499
Petrescu, M. and Wedow, M. (2017) Dark Pools in European Equity Markets: Emergence, Competition
and Implications, ECB Occasional Paper No. 193. Available at: https://ssrn.com/abstract=3008485

Ye, L. (2016) Understanding the impacts of dark pools on price discovery, Working Paper. Chinese
University of Hong Kong. Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2874957

Zhu, H. (2014) ‘Do dark pools harm price discovery?’. The Review of Financial Studies, 27 (3), pp.747-
789.