Dark Trading and Equity Market Quality

Abstract

Off-exchange trading in equity markets, including broker/dealer internalization and dark pools, has grown in recent years. An examination of the relationship between dark trading and market quality suggests that as dark trading increases, the marginal benefit from it declines. Beyond a certain threshold, increases in dark trading may be associated with deteriorating market quality. The level of this threshold is related to the type of dark trading and the market capitalization of the stock.

Over the past decade, equity markets have undergone a significant structural change due to the combined forces of technology, regulation, globalization and competition. Trading has become increasingly automated, fast-paced, competitive, and spatially dispersed. This evolution has been accompanied by a decrease in average trade size and a significant increase in overall quote traffic and transaction volumes. Trading costs have fallen while liquidity has become increasingly fragmented over multiple venues.

In particular, the fragmentation of liquidity has been associated with a significant shift of trading volume away from the primary listing markets and toward undisplayed off-exchange trading venues, including broker/dealer internalization and dark pools. Investors and regulators have raised a number of concerns about these changes in market structure. First, there has been a perceived degradation of market transparency arising from the growth in dark trading and the corresponding fall in the market share of “lit” venues. Second, an uneven playing field between different types of trading venues and between different classes of investors in terms of access to markets can distort competition and fairness. Finally, there is a greater potential for systemic risk propagation as a result of the market’s dependence on automation and its interconnectedness. A more fundamental concern associated with the growth in dark trading is that the willingness of investors to post displayed limit orders—the building blocks of price discovery—could be harmed if a significant proportion of orders are filled off exchange at the expense of the limit order submitter. This scenario could disincentivize investors from using the lit markets.

To determine whether investors and regulators are right to be concerned about developments in equity market structure, the relation between dark trading and market quality is examined. We look at the impact of dark trading on two proxies for market quality: bid–offer spreads and top-of-book market depth. The results of this analysis suggest that an increase in dark pool activity and internalization is initially associated with an improvement in market quality but that this improvement persists only up to a certain threshold. When a majority of trading occurs in undisplayed venues, market quality benefits disappear and may actually reverse.