Welfare Analysis of Dark Pools

45 Pages Posted: 16 Apr 2012 Last revised: 2 Dec 2016

Krishnamurthy Iyer

School of Operations Research and Information Engineering, Cornell University

Ramesh Johari

Stanford University

Ciamac C. Moallemi

Columbia Business School - Decision Risk and Operations

Date Written: Dec 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 (Dec 1, 2016). Available at SSRN: https://ssrn.com/abstract=2040959 or http://dx.doi.org/10.2139/ssrn.2040959

Krishnamurthy Iyer (Contact Author)

School of Operations Research and Information Engineering, Cornell University ( email )

225 Rhodes Hall
Ithaca, NY 14853
United States

HOME PAGE: http://https://people.orie.cornell.edu/kriyer/index.html

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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