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 market.

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.

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.