Welfare Analysis of Dark Pools

52 Pages Posted: 16 Apr 2012 Last revised: 15 Jul 2018

See all articles by Krishnamurthy Iyer

Krishnamurthy Iyer

University of Minnesota - Twin Cities - Department of Industrial and Systems Engineering

Ramesh Johari

Stanford University

Ciamac C. Moallemi

Columbia University - Columbia Business School, Decision Risk and Operations

Date Written: December 1, 2016

Abstract

We investigate the role of a class of alternative market structures known as electronic crossing networks or "dark pools''. Relative to traditional "lit'' markets, dark pools offer investors the trade-off of reduced transaction costs in exchange for greater uncertainty of trade. Our paper studies the welfare implications of operating a dark pool alongside traditional lit markets. We study equilibria of a market with intrinsic traders and speculators, each endowed with heterogeneous fine-grained information, who endogenously choose between dark and lit venues. We establish that while dark pools attract relatively uninformed investors, the orders therein experience an implicit transaction cost in the form of adverse selection. On the other hand, we show that dark pools facilitate trade between relatively less informed intrinsic traders and speculators, inducing a positive liquidity effect on welfare. We study the interplay of these countervailing pressures on market welfare, and quantify regimes in which the welfare rises or falls upon the introduction of a dark pool.

Keywords: dark pools, welfare, adverse selection, competitive markets

JEL Classification: C70, C72, D40, D41, G10, G14, G18, G20

Suggested Citation

Iyer, Krishnamurthy and Johari, Ramesh and Moallemi, Ciamac C., Welfare Analysis of Dark Pools (December 1, 2016). Available at SSRN: https://ssrn.com/abstract=2040959 or http://dx.doi.org/10.2139/ssrn.2040959

Krishnamurthy Iyer (Contact Author)

University of Minnesota - Twin Cities - Department of Industrial and Systems Engineering ( email )

111 Church St SE
Minneapolis, MN 55455
United States

Ramesh Johari

Stanford University ( email )

473 Via Ortega
Stanford, CA 94305-9025
United States

Ciamac C. Moallemi

Columbia University - Columbia Business School, Decision Risk and Operations ( email )

New York, NY
United States

HOME PAGE: http://moallemi.com/ciamac

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