Aggregate market quality implications of dark trading

Over the last decade, regulatory changes, coupled with technological advancements, led to the proliferation of new classes of trading venues. One of the most prominent new trading venue types is a class of venues known as ‘dark pools’. Trades executed on dark pools have no pre-trade transparency. Other market participants apart from the submitter and the pool operator are not aware of orders submitted to a dark pool before their execution.

Many dark pools in Europe are operated as Multilateral Trading Facilities (MTFs). For example, the three largest dark trading venues on the continent are MTFs, which operate both dark and lit order books. These are Chi-X Europe, BATS Europe and Turquoise; all are based in London. As a proportion of European exchange volumes are now executed ‘in the dark’, it is vital to investigate how these volumes impact overall market quality. This investigation is of critical importance for investors, who already view dark pool activity with suspicion, and regulators, who are interested in having well-functioning financial markets.

This study contributes to the dark pools debate by presenting the first evidence on the impact of dark trading on aggregate market quality in Europe. The study is also the most comprehensive examination to date of dark trading in Europe, since we explore dark trading across all the major trading venues in the UK.

We use data for the whole universe of FTSE350 stocks and the period June 2010 to June 2015 to test competing theoretical predictions on the implications of dark trading on the quality of the aggregate market, comprising both the lit and dark sections. We find that, at current levels, dark trading does not appear to be harmful to market quality in the aggregate UK equity market. Our results imply that there is a threshold at which dark trading may start to negatively affect market quality. We estimate that threshold, for our full sample of stocks, to be when dark trading value is approximately between 11% and 17% of total trading by pound value, depending on the specific market quality attribute examined. We discuss caveats for these estimates in the paper.