Dark Pools under Different Execution Priority, Adverse Selection and Traders' Competition
54 Pages Posted: 31 Mar 2020 Last revised: 19 Aug 2020
Date Written: July 31, 2020
Traders, nowadays, can perform transactions not only in traditional exchanges (lit markets) but also in dark pools, which account for almost half of the stock market in the United States. Nevertheless, we still lack clear knowledge of the effect of this type of trading activity on market quality. Actually, different empirical studies have shown opposing results on the effect of dark pools on market performance. The objective of our paper is to provide an explanation for such mixed results and pin down the role of dark pools. We present a realistic dynamic model, which we use to analyze the impact of the introduction of a dark pool in parallel to a limit order market. We find that traders’ choice between lit and dark trading venues depends on market conditions, which are affected by execution priority rules in the dark pool, adverse selection, and traders' competition in order submissions. We show that dark trading activity has a non-linear relationship with asset volatility and liquidity, which explains previous mixed empirical results regarding the impact of dark pools on market quality. The introduction of dark pools increases welfare only for speculators, while other traders (even large traders) are worse off. Moreover, we show that a size execution priority rule improves welfare relative to a time execution priority for dark orders.
Keywords: Dark pool; limit order market; execution priority; adverse selection; competition of traders; market quality; welfare
JEL Classification: C63, C73, D40; D81; G11, G14
Suggested Citation: Suggested Citation