Information and Optimal Trading Strategies with Dark Pools

Abstract

We examine the competition between a transparent exchange organized as a limit order book and an opaque dark pool in the presence of asymmetric information. We show that price informativeness is generally lower when the dark pool and the exchange coexist. However, price informativeness might increase in the second trading period if there is no initial order migration to the dark pool. We also find that market liquidity increases initially for high fundamental volatility stocks and decreases for low liquidity stocks. Therefore, the impact of a dark pool that coexists with an exchange on market quality depends on stock market characteristics (fundamental volatility, liquidity, and adverse selection) and traders' characteristics (immediacy and information), and this allows us to derive new empirical and policy implications from our analysis.

Keywords: trading venues, dark liquidity, limit order book, price risk, adverse selection

JEL Classification: G12, G14, G18