Dark Trading on Public Exchanges

Abstract

Over the last decade, market participants increasingly use trading tools that allow them to hide their trading intentions. We study how “dark trading” in the form of fully hidden, or dark, orders posted on a visible exchange affects the quality of the visible market. Dark orders were introduced on the Toronto Stock Exchange in 2011 in two stages, allowing us to employ a difference-in-differences approach to isolate the causal effect of the availability of dark trading. Using order-level data, we observe that the introduction of dark orders led to a widening of quoted spreads and an increase in trading costs, leaving depth, volume, and volatility unaffected. At the intra-day level, dark trading leads to decreased quoted spreads, increased depth, increased volume and to reduced trading costs and volatility. We interpret our findings as two sides of the same coin: the possible presence of dark liquidity causes market participants to post visible quotes more carefully. Upon detecting dark executions, however, traders infer that dark liquidity is diminished and thus post quotes more aggressively.

Keywords: dark trading, midpoint orders, limit order book trading

JEL Classification: G14, G18