Understanding the Impacts of Dark Pools on Price Discovery
67 Pages Posted: 27 Nov 2016
Date Written: October 1, 2016
This paper investigates the impact of dark pools on price discovery (the eﬃciency of prices on stock exchanges to aggregate information). Assets are traded in either an exchange or a dark pool, with the dark pool oﬀering better prices but lower execution rates. Informed traders receive noisy and heterogeneous signals about an asset’s fundamental. We ﬁnd that informed traders use dark pools to mitigate their information risk and there is a sorting eﬀect: in equilibrium, traders with strong signals trade in exchanges, traders with moderate signals trade in dark pools, and traders with weak signals do not trade. As a result, dark pools have an ampliﬁcation eﬀect on price discovery. That is, when information precision is high (information risk is low), the majority of informed traders trade in the exchange hence adding a dark pool enhances price discovery, whereas when information precision is low (information risk is high), the majority of the informed traders trade in the dark pool hence adding a dark pool impairs price discovery. The paper reconciles the conﬂicting empirical evidence and produces novel empirical predictions. The paper also provides regulatory suggestions with dark pools on current equity markets and in emerging markets.
Keywords: Dark Pool, Market Fragmentation, Information Asymmetry, Price Discovery
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