Department of Accounting and Finance

MSc. Finance (2017)

AG912 International Financial Markets and Banking

TZAVIDAS PANAGIOTIS
Registration Number: 201774398

Lecturer: JulianeThamm
Task C:
Should dark pools be prohibited? Discuss this statement by
exclusively presenting arguments that this is indeed the case.

Date of Submission:

6thNovember 2017
Dark pools are systemized venues for trading equities without any transparency prior to
order execution. (Pan, 2017). Preece (2012), the director of CFA Institute, also mark that the
orders submitted in dark pools, are not only concealed from others market participants, but
they are also matched anonymously against opposite orders. There are many people, among
me, who believe that the disadvantages of dark pools outweigh the advantages. The purpose
of this essay is to present the main reasons why dark pools should be prohibited, focusing
foremost on how they impact the market quality and sustainability.

To begin with, Ibelieve that dark pools have a considerably negative impact on market
quality, and especially on price discovery. Price discovery is the procedure of determining
the market price of an asset, based among others on supply and demand factors (Dodd,
2004). According to O. Hara (2003), the provision of price discovery is one of the most crucial
factors for a trading market. Dark pools do not expose to the public any information about
their trades until these have been executed.Even if they do so, primarily because they are
forced by the regulation, this post-trade information is commonly not accepted and not
confirmed (Technical Committee of IOSCO, 2010). And as Ye (2016) argued in her model,
price discovery depends significantly on the precision of the given information. As a result, a
reducing amount of information could easily lead to more volatile prices, increasing in that
way the risk of the execution. Apart from this, Clark et al claimed (2009) that there are some
dark pools, which they do not provide an appropriate number of trades. Thus, it is much
more difficult for the uninformed trader to find with accuracy the price for an asset. Prices
are not established according to supply’s and demand’s norms and this explains why in many
cases traders have to make their own research. Kyle (1985) and Glosten and Milgrom (1985)
pointed out that the more expensive the information is, the fewer uninformed traders exist
in the market, and this could easily lead to the failure of the price discovery process. This
fact becomes more ominous, especially nowadays, as the proportion of the dark pools has
been increased (IOSCO, 2010). European Commission (2010) and Securities and Exchange
Commission (SEC, 2010) have expressed many concerns about this growth and its impact on
price discovery. Aquilina et al. (2017) noted that there is a highly interaction between
market quality and dark pools, because larger levels of dark trading will have considerably
harmful impacts to market quality. Moreover, Comerton-Forde and Putnins (2015) observed
that, increasing levels of dark trading lead not only to less objective prices, but also to less
efficient information. Despite the fact there is no negative effect if everyone publishing their
information, when only a few are doing so, they are in a disadvantageous position. Hence, as

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far as I am concerned, I think that the growth of dark pools deteriorates the process of price
discovery.

Furthermore, from my point of view, another major effect of dark pools is the fragmentation
of liquidity and information. As it is mentioned above, dark pools affect in a negative way the
process of price discovery, since the information becomes more prized. Except for this, the
participants in these dark trading venues have different levels of access to information and
most times they continued to be anonymous after the execution of an order (Lopez, 2013).
According to O’ Hara and Ye (2011), there is a strong relation between price discovery and
liquidity as they are both associated with the information which is provided from dark pools.
As dark pools increase, each one has its own rules and it is subjected to different regulations.
Therefore, it is much more difficult for traders to seek out the information they need,
especially when this is not easy-readable and when only the necessary information for
matching orders is available (Boni, Brown and Leach, 2012). As the Technical Committee of
IOSCO stated (2010), traders, especially the uninformed, most times they are compelled to
make their own research, in order to be sure for their decision. In this way, the time and the
cost of the execution are increased. Moreover, Yin (2005) noticed that both the increasing
cost and the fragmentation have a negative impact on liquidity, because they lead to less
competition among the liquidity providers. Liquidity seems to be highly associated with the
speed of the transaction, and owning to the high volatility of prices, traders whose orders
are executed later than others are in a negative situation. Apart from this, as Garvey, Huang
and Wu (2016) and Degryse et al. (2015) stated that there are serious differences in liquidity
between lit values and dark pools. They both proved that, because there is not enough
liquidity in dark pools, the execution of an order not only lasts longer, but there is also a high
possibility that the price will have significant fluctuations between the time that an order
was placed and the time that it was executed. Continuing this statement, Degryse, de Jong,
and van Kervel (2011) observed that although fragmentation seems to be beneficial for
venues provide transparency, dark trading has a destructive effect on global liquidity. Thus,
to my way of thinking, the existence of dark pools has a negative result on market efficiency
and liquidity. Finally, almost all regulators deem transparency as one of the most major
elements for trading venues, in order these to provide fair and efficient liquidity. But most
times dark pools operate automatically, using algorithms to match trades. As SEC (2016)
noticed, Credit Suisse and Barclays Capital paid recently a significant amount of million in
fines for not executing properly their orders. As a result, this opaque essence creates many
worries and concerns, and this is maybe one of the reasons why most of the informed

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traders prefer to trade on lit markets rather than on dark pools, affecting in this way the
provided liquidity and the sustainability of the market.

To sum up, for all the reasons presented above, I believe that dark pools have a negative
impact on the sustainability of the market, because they deteriorate the price discovery, and
therefore they should be prohibited.

Word count: 1038

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