Two-sided dark trading is beneficial to market quality, reducing spreads, improving
liquidity, and increasing informational efficiency; but one-sided dark trading does not
significantly affect market quality. Dark limit order markets facilitate increased
competition in liquidity provision, which improves price discovery. Policy implications
for dark trading and tick size regulations are also explored.
How Is This Research Useful to Practitioners?
Dark pools are private exchanges or forums for trading securities. Unlike stock exchanges,
dark pools are not accessible by the investing public. Also known as “dark pools of
liquidity,” dark pools are so named for their complete lack of transparency. Dark
pools came about primarily to facilitate block trading by institutional investors that did
not want to affect the markets with their large orders and thereby obtain adverse prices for
their trades. The authors refer to two types of dark trades: One-sided trades occur at a
single price (e.g., the midpoint of the national best bid–offer spread); two-sided
trades may occur at different prices on both the buy side and the sell side of the
The authors conducted their research using Canadian and Australian stocks. Given the
material differences between Canadian and Australian markets, the comparable results support
the robustness of the effects of dark trading and the ability to generalize the
authors’ findings to such other markets as the United States.
Despite its ominous-sounding name, the authors find that two-sided dark trading can
consistently benefit liquidity and improve price discovery. Less pre-trade transparency in
limit order markets helps informed traders supply liquidity because they can profit from
liquidity provision without revealing private information. The authors’ results
indicate that strong competition in providing dark liquidity forces lit market liquidity
providers to narrow spreads in order to compete. Robust liquidity provision in the dark also
improves price discovery.
The large number of lit and two-sided dark trading venues of various sizes can benefit
liquidity by increasing the number of liquidity providers, encouraging liquidity provision,
and allowing liquidity providers to compete on a finer pricing grid. Conversely, the authors
find that one-sided trading does not affect market quality.
How Did the Authors Conduct This Research?
To analyze dark trading in Canada, the authors examine the TSX Composite Index, composed of
250 of the most liquid Canadian stocks, for a period of two months before and two months
after the introduction of minimum price improvement rules (effective 15 October 2012). They
obtain tick-by-tick proprietary data on both dark and lit trades executed on MATCHNow, Alpha
IntraSpread, Chi-X Canada, and TSX from the trading venues. They obtain similar trade-level
data for a matched sample of US stocks to control for changes in market characteristics
driven by factors other than dark trading. To analyze dark trading in Australia, the authors
use the ASX 200 Index, composed of 200 of the most actively traded Australian stocks, for a
period of two months before and two months after the introduction of minimum price
improvement rules (effective 26 May 2013).
The authors’ analysis starts with univariate pre-/post-comparisons of mean market
characteristics for marketwide dark and lit trading activity in Canada. They perform
least-squares panel regressions of market quality metrics on dark trading and control
variables for both the Canadian markets and the Australian markets.
The authors’ research on dark trading and liquidity strongly reinforces the notion
that one-sided dark trading and two-sided dark trading have different effects on market
quality. Two-sided dark trading is more consistently beneficial than one-sided dark trading,
and the effects of the aggregate level of dark trading depend on the mix of one-sided and
two-sided dark trading. Policymakers should clearly distinguish between the different types
of dark trading when developing policy because dark trading should be considered a
heterogeneous group. In addition, regulators should note that minimum price improvement
requirements can be enhanced by ensuring that tick sizes do not force two-sided dark markets
out of existence.