Dark Pools under Different Execution Priority, Adverse Selection and Traders' Competition

54 Pages Posted: 31 Mar 2020 Last revised: 19 Aug 2020

See all articles by Alejandro Bernales

Alejandro Bernales

Universidad de Chile

Daniel Ladley

University of Leicester - School of Business

Evangelos Litos

University of Leicester - School of Business

Marcela Valenzuela

Pontificia Universidad Católica de Chile

Date Written: July 31, 2020

Abstract

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

Bernales, Alejandro and Ladley, Daniel and Litos, Evangelos and Valenzuela, Marcela, Dark Pools under Different Execution Priority, Adverse Selection and Traders' Competition (July 31, 2020). Available at SSRN: https://ssrn.com/abstract=3549955 or http://dx.doi.org/10.2139/ssrn.3549955

Alejandro Bernales (Contact Author)

Universidad de Chile ( email )

Diagonal Paraguay 257
Santiago
Chile

HOME PAGE: http://www.alejandrobernales.com

Daniel Ladley

University of Leicester - School of Business ( email )

University Road
Leicester, LE1 7RH
United Kingdom

Evangelos Litos

University of Leicester - School of Business ( email )

University Road
Leicester, LE1 7RH
United Kingdom

Marcela Valenzuela

Pontificia Universidad Católica de Chile ( email )

Vicuña Mackenna 4860
Santiago, R. Metropolitana 7520421
Chile

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