City Goes Dark: Dark Trading and Adverse Selection in Aggregate Markets

49 Pages Posted: 16 Aug 2016 Last revised: 3 May 2018

See all articles by Matteo Aquilina

Matteo Aquilina

Financial Conduct Authority

Ivan Diaz-Rainey

University of Otago - School of Business

Gbenga Ibikunle

University of Edinburgh; European Capital Markets Cooperative Research Centre

Yuxin Sun

Queen's University Belfast - Queen's Management School

Date Written: August 1, 2017

Abstract

We present the first evidence of the impact of dark trading on adverse selection in an aggregate market. At moderate levels of dark trading, a positive liquidity effect dominates an information acquisition disincentive effect, such that dark trading induces reductions in both adverse selection risk and pricing noise, while enhancing liquidity. However, there is a trading value-based threshold when dark trading starts to induce adverse selection. We estimate this threshold to vary between 9% for the most liquid FTSE350 index stocks to 35% for the least liquid stocks in the index. The overall FTSE 350 index average threshold is 16%.

Keywords: dark pools, aggregate markets, adverse selection, market liquidity, pricing noise

JEL Classification: G10, G14, G15

Suggested Citation

Aquilina, Matteo and Diaz-Rainey, Ivan and Ibikunle, Gbenga and Sun, Yuxin, City Goes Dark: Dark Trading and Adverse Selection in Aggregate Markets (August 1, 2017). FCA Occasional Paper No. 29. Available at SSRN: https://ssrn.com/abstract=2824352 or http://dx.doi.org/10.2139/ssrn.2824352

Matteo Aquilina

Financial Conduct Authority ( email )

25 The North Colonnade
Canary Wharf
London, E14 5HS
United Kingdom

Ivan Diaz-Rainey

University of Otago - School of Business ( email )

Dunedin
New Zealand

Gbenga Ibikunle (Contact Author)

University of Edinburgh ( email )

Old College
South Bridge
Edinburgh, Scotland EH8 9JY
United Kingdom

European Capital Markets Cooperative Research Centre ( email )

Viale Pidaro 42
Pescara, 65121
Italy

Yuxin Sun

Queen's University Belfast - Queen's Management School ( email )

Office 0G-018
185 Stranmillis Road
Belfast, BT9 5EE
United Kingdom

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