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Insight | Should we be afraid of (trading in) the dark?

19 November 2017

Dr Gbenga Ibikunle makes the case for dark pool trading…up to a point.

During the past decade, regulators in the US and EU have increased their efforts to make financial markets more transparent and fairer.

2005’s Regulation National Market System (Reg NMS) in the US and the 2007 Market in Financial Instruments and Directive (MiFID) in the EU broke the monopoly of exchanges like the London Stock Exchange.

Meanwhile advances in technology have seen the rise of a new class of exchange, in many cases making it easy to trade from a smart phone at the click of a button. One such of these new classes – ‘dark pools’ have sparked a lot of interest and debate among the financial community.

In normal ‘lit’ exchanges, each investor can see the prices others are willing to buy and sell at, and the size of each trade. But in dark pools the situation is much more opaque – with only the sale price of previous trades made public.

In European markets, the total value of dark trades stood at more than €898 billion for the 12-month period ending March 2014, representing more than 9.6% of all equity trades on the continent. While in the US, dark trades were estimated to constitute around 31% of market activity in 2012.

The reasons for the attraction are numerous, particularly for large institutional investors such as pension funds. Not only do they offer such firms the opportunity to execute large trades while avoiding significant price impacts – in normal exchanges such movements can reduce the selling price as they dramatically increase supply.

In most cases, they provide better prices than lit venues, since they are more likely to be motivated by a need to liquidate a stock (i.e. to return cash to investors in the form of pension payments) than to trade instruments for profit.

But this growth in dark trading has raised questions about the impact on traditional markets, which are underpinned by the interaction between these large institutions and informed traders.

The latter rely on institutional investors’ urgency to cash-in their stock and their superior market knowledge to profit from buying below the real market value. It’s this gap in information between buyers and sellers – known as adverse selection – that keeps markets moving.

If every large institution was to move to dark markets, there would be no advantage in knowledge and no incentive for informed investors to trade. With fewer trades, price discovery in markets would suffer, meaning some stock could be overvalued and some undervalued. The implication being that everyone – including pension holders who could find the value of their investment fall – loses. In theory at least.

Understandably, this has regulators worried. But until now, very little has been done to test the hypothesis and establish the true impact of dark trading.

Myself, Business School PhD Yuxin Sun, FCA economist, Matteo Aquilina and Ivan Diaz-Rainey from the University of Otago set about trying to shed some light on these opaque exchanges.

Recently published by the Financial Conduct Authority, our study aggregates data from the UK’s four main trading venues – LSE, BATS Europe, Chi-X Europe and Turquoise – on 288 of the largest stocks in the London’s FTSE 350, between 2010 and 2015.

Contrary to general expectations, our results suggest the levels of dark trading we see in London today are not harmful to overall market quality. In fact, we found that dark trading is actually beneficial for market liquidity up to around 15% of total trading – if measured in value.

What’s more, for less liquid stocks, dark trades benefit overall market liquidity by up to 35%. Here, where trades are more sporadic, it is likely investors choose to trade outside of the lit exchange so they can reduce their activity’s impact on prices and maximise returns.

Due to take effect in January 2018, the new European Union Markets in Financial Instruments Directive II (MiFID II) regulations will see dark trades limited to no more than 8% for each stock.

Where its 2007 predecessor has been celebrated for breaking historic monopolies and democratising financial markets, the question now is whether these new rules could actually harm overall market quality. Our research suggests – at current levels of activity at least – such action to tackle dark pools could in fact be more detrimental than taking no action at all.


Dr Gbenga Ibikunle is Senior Lecturer in Financial Markets at University of Edinburgh Business School. An earlier version of this post originally appeared as a Financial Conduct Authority Insight.

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