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Welfare Analysis of Dark Pools

Krishnamurthy Iyer

Cornell University - Operations Research & Industrial Engineering

Ramesh Johari

Stanford University

Ciamac C. Moallemi

Columbia Business School - Decision Risk and Operations

May 12, 2016

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. Moreover, the informational segmentation created by a dark pool leads to greater transaction costs in lit markets. Taken together, we establish that there exist reasonable parameter regimes where the introduction of a dark pool decreases the overall welfare of market participants.

Number of Pages in PDF File: 45

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

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

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Date posted: April 16, 2012 ; Last revised: May 13, 2016

Suggested Citation

Iyer, Krishnamurthy and Johari, Ramesh and Moallemi, Ciamac C., Welfare Analysis of Dark Pools (May 12, 2016). Available at SSRN: http://ssrn.com/abstract=2040959 or http://dx.doi.org/10.2139/ssrn.2040959

Contact Information

Krishnamurthy Iyer (Contact Author)
Cornell University - Operations Research & Industrial Engineering ( email )
237 Rhodes Hall
Ithaca, NY 14853
United States
Ramesh Johari
Stanford University ( email )
473 Via Ortega
Stanford, CA 94305-9025
United States
Ciamac C. Moallemi
Columbia Business School - Decision Risk and Operations ( email )
New York, NY
United States
HOME PAGE: http://moallemi.com/ciamac

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