The following paper will introduce dark pools and present as well as discuss some of the most important arguments in favour of prohibiting dark pools.
Dark pools have been in existence since the 1980s with the first one being founded by Instinet in 1986. However, according to Zhu (2014), there was little interest in dark pools as they only had a very low market share. The author states that this changed in 2007 when both the United States of America as well as the European Union implemented new legislation – the Regulation National Market System (Reg NMS) and the Markets in Financial Instruments Directive (MiFID) respectively – which led to a significant increase in the number of both dark pools and trades on these platforms.
The International Organization of Securities Commissions (IOSCO) (2010) generally defines dark pools as electronic liquidity pools which do not publicly provide any share prices before the trade. This lack of pre-trade transparency thus enables equity investors to trade privately, contrary to public stock exchanges, often referred to as lit markets. According to Lovén (2013), the main purpose of dark pools is twofold, firstly to minimise market impact and secondly to offer improvements of trading prices. To achieve this, dark pools usually execute orders at the midpoint of the bid-offer spread with the latter being sourced from lit exchange prices.
Table of Contents
1. Introduction
2. Discussion
Objectives and Topics
The primary objective of this paper is to examine the nature of dark pools and to present a critical discussion of the central arguments supporting the prohibition of these trading platforms, specifically focusing on their impact on market integrity and efficiency.
- The evolution and definition of dark pools in financial markets.
- The negative influence of dark pool trading on price discovery processes.
- The erosion of public market liquidity due to the migration of orders.
- Risks regarding market abuse, lack of transparency, and predatory high-frequency trading (HFT) tactics.
Excerpt from the Book
2. Discussion
The first major argument in favour of prohibiting dark pools is their negative impact on price discovery and public market liquidity. Both the IOSCO (2010) as well as the European Commission (2010) support this, arguing that dark pool trading may indeed harm the price discovery process on public exchange markets. To understand this argument, it is imperative to understand the concept of price discovery first. The IOSCO (2010, p. 19) describes it as “the process through which the current market price for a security is established for, among other things, effecting an execution or valuing an existing holding”.
It is further stated that during this process, a security’s supply and demand is analysed and the information obtained by this analysis results in the discovery of the public market price of this security. The more information is available, the more accurate is the price. Thus, transparency is a vital factor of the price discovery process.
Since there is no information on the supply and demand of a security in dark pools, this transparency is not available to its participants. The IOSCO (2010) therefore argues that the lack of pre-trade price information inhibits the true execution of the price discovery mechanism and, consequently, leads to a divergence from the prices in lit exchange markets. Furthermore, Hadfield (2017) observes a surge in dark trading over the last few years, with the percentage of European equities traded in dark pools rising from approximately one per cent in 2010 to roughly five per cent in 2017. According to Foley, Malinova and Park (2013), these developments, in turn, put participants of public exchanges at an enormous disadvantage as their search and identification of valuable investment opportunities is impeded by the reduced liquidity in the lit market. Ultimately, this is not only harmful to the lit markets’ overall trading quality but Aquilina et al. (2017) believe that it also leads to a widening of its bid-offer spread.
Summary of Chapters
1. Introduction: This chapter introduces the history and definition of dark pools, highlighting the increase in their usage following the implementation of major financial regulations in 2007.
2. Discussion: This chapter critically analyzes the arguments for prohibiting dark pools, focusing on their detrimental effects on price discovery, market liquidity, and their susceptibility to abuse by high-frequency traders.
Keywords
Dark pools, price discovery, liquidity, transparency, lit markets, financial regulation, high-frequency trading, HFT, market abuse, pre-trade transparency, MiFID, Reg NMS, equity trading, order execution, market integrity
Frequently Asked Questions
What is the core subject of this paper?
The paper examines the role of dark pools in modern financial markets and provides arguments supporting the case for their prohibition.
What are the primary thematic areas covered?
The analysis focuses on market transparency, the mechanics of price discovery, the impact on public exchange liquidity, and the potential for predatory trading practices.
What is the central research question?
The paper seeks to explore and justify the argument that dark pools should be prohibited due to their negative impacts on the efficiency and fairness of financial markets.
Which scientific methodology is applied?
The paper employs a literature review and synthesis of regulatory reports and academic studies to analyze the systemic risks posed by dark pools.
What is discussed in the main body?
The main body discusses how the lack of pre-trade transparency harms price discovery and how the platform's structure facilitates predatory activities like front-running by high-frequency traders.
Which keywords characterize this paper?
Key terms include dark pools, price discovery, liquidity, market transparency, high-frequency trading, and regulatory oversight.
How do high-frequency traders abuse dark pools?
High-frequency traders use algorithms to "ping" dark pools to detect large hidden orders, which then allows them to engage in front-running for profit.
Why is the lack of "lit" market transparency considered a disadvantage?
Because dark pools operate without public price transparency, investors are unable to gauge market depth, which leads to higher costs and decreased efficiency in order execution.
- Citar trabajo
- Sabrina Schleimer (Autor), 2017, Why should Dark Pools be prohibited?, Múnich, GRIN Verlag, https://www.grin.com/document/437649
