The following paper will introduce dark pools and present as well as discuss some of the most important arguments in favour of prohibiting dark pools.
Dark pools have been in existence since the 1980s with the first one being founded by Instinet in 1986. However, according to Zhu (2014), there was little interest in dark pools as they only had a very low market share. The author states that this changed in 2007 when both the United States of America as well as the European Union implemented new legislation – the Regulation National Market System (Reg NMS) and the Markets in Financial Instruments Directive (MiFID) respectively – which led to a significant increase in the number of both dark pools and trades on these platforms.
The International Organization of Securities Commissions (IOSCO) (2010) generally defines dark pools as electronic liquidity pools which do not publicly provide any share prices before the trade. This lack of pre-trade transparency thus enables equity investors to trade privately, contrary to public stock exchanges, often referred to as lit markets. According to Lovén (2013), the main purpose of dark pools is twofold, firstly to minimise market impact and secondly to offer improvements of trading prices. To achieve this, dark pools usually execute orders at the midpoint of the bid-offer spread with the latter being sourced from lit exchange prices.
1. Introduction
The following paper will introduce dark pools and present as well as discuss some of the most important arguments in favour of prohibiting dark pools.
Dark pools have been in existence since the 1980s with the first one being founded by Instinet in 1986 (Foley, Malinova and Park, 2013; What Are Dark Pools, 2017). However, according to Zhu (2014), there was little interest in dark pools as they only had a very low market share. The author states that this changed in 2007 when both the United States of America as well as the European Union implemented new legislation - the Regulation National Market System (Reg NMS) and the Markets in Financial Instruments Directive (MİFID) respectively - which led to a significant increase in the number of both dark pools and trades on these platforms.
The International Organization of Securities Commissions (IOSCO) (2010) generally defines dark pools as electronic liquidity pools which do not publicly provide any share prices before the trade. This lack of pre-trade transparency thus enables equity investors to trade privately, contrary to public stock exchanges, often referred to as lit markets. According to Lóvén (2013), the main purpose of dark pools is twofold, firstly to minimise market impact and secondly to offer improvements of trading prices. To achieve this, dark pools usually execute orders at the midpoint of the bid-offer spread with the latter being sourced from lit exchange prices (Definition of dark pools, 2017; Zhu, 2014).
2. Discussion
The first major argument in favour of prohibiting dark pools is their negative impact on price discovery and public market liquidity. Both the IOSCO (2010) as well as the European Commission (2010) support this, arguing that dark pool trading may indeed harm the price discovery process on public exchange markets. To understand this argument, it is imperative to understand the concept of price discovery first. The IOSCO (2010, p. 19) describes it as “the process through which the current market price for a security is established for, among other things, effecting an execution or valuing an existing holding”.
It is further stated that during this process, a security’s supply and demand is analysed and the information obtained by this analysis results in the discovery of the public market price of this security. The more information is available, the more accurate is the price. Thus, transparency is a vital factor of the price discovery process.
Since there is no information on the supply and demand of a security in dark pools, this transparency is not available to its participants. The IOSCO (2010) therefore argues that the lack of pre-trade price information inhibits the true execution of the price discovery mechanism and, consequently, leads to a divergence from the prices in lit exchange markets. Furthermore, Hadfield (2017) observes a surge in dark trading over the last few years, with the percentage of European equities traded in dark pools rising from approximately one per cent in 2010 to roughly five per cent in 2017. According to Foley, Malinova and Park (2013), these developments, in turn, put participants of public exchanges at an enormous disadvantage as their search and identification of valuable investment opportunities is impeded by the reduced liquidity in the lit market. Ultimately, this is not only harmful to the lit markets’ overall trading quality but Aquilina et al. (2017) believe that it also leads to a widening of its bid-offer spread.
In addition to this, the above mentioned increase of opaque orders and transactions, which harms the price discovery process, also results in another phenomenon, namely the movement of smaller orders to dark pools which used to be traded publically (IOSCO, 2010). In this context, Zhu (2014) notes that upon establishment and during their early years, dark pools were almost exclusively used to trade large block orders, with the aim of ensuring that the market would not be alarmed by these trades. Lóvén (2013) analyses, however, that with an increased number of smaller orders being executed within the dark pools, this development also has a negative impact on both the public market’s liquidity as well as its overall price discovery process.
To sum up dark pools’ harmful influence on price discovery, it is interesting to see this argument confirmed by 71 per cent of market participants in a CFA institute survey (Aquilina et al., 2017).
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- Sabrina Schleimer (Autor), 2017, Why should Dark Pools be prohibited?, Múnich, GRIN Verlag, https://www.grin.com/document/437649
