Fragmentation and Consolidation of Dark and Lit Order Books

Abstract

Since the implementation of MiFID on November 1 2007 European financial markets have experienced fragmentation in displayed (lit) order books as well as an increase in the use of non-displayed (dark) liquidity. We empirically analyze the effects such events have on market quality. We find that increased competition for orders resulting from the fragmentation of the displayed liquidity market improves market quality in the form of tighter bid/ask spreads and lower transaction costs. Fragmentation between lit and dark order books has a negative impact on market quality as informative trades migrate from lit to dark order book markets leading to greater information asymmetry among market participants. This results in wider bid/ask spreads and greater price impacts as investor confidence in advertised prices decreases and depth moves further from the midpoint of the best bid/ask spread. Increased dark order book fragmentation negatively effects market quality in the form of wider quoted spreads, however the magnitude of the effect is minimal.

Keywords: Dark pools, off-exchange, fragmentation

JEL Classification: G12, G15, G18