Transparency is one of the most debated issues in securities market regulation. The myth that all market participants are perfectly informed about past trades and potential new ones is a long way from the markets’ actual behaviour. Whether you are a retail investor or a mutual fund manager, whether you trade in a relatively transparent sector or an OTC market, you need to hire a broker, and incur additional costs, if you wish to have (almost) perfect information and a full picture of the trading process. The bottom line is that these professionals quote prices, so it is essential for their business that they have access to as much information as possible.

Where quotes are visible before incoming orders execute against the standing bid or ‘ask’, the market is lit. Where this is not the case, the trade is ‘dark’. Dark markets, or ‘Pools’ are becoming increasingly popular as technical improvements enable High Frequency Trading (HFT): low latency reduces costs for market participants using speed as their advantage. MiFID regulations are also enhancing the attractiveness of dark pools - the increased transparency has made it more difficult to hide trades, so dark pools provide an opportunity to reduce transparency and exposure to information leakage.

Dark pools of liquidity may be either simple negotiation venues where the negotiation of the final price happens, or a crossing network where traders submit direction and quantity, but the price is taken from another market as reference, so that buy and sell side are matched by free riding the prices determined by the National Best Bid and Offer (NBBO).

The Benefits of Dark Pools

The existence of dark pools has some advantages but carries a lot of disadvantages as well; not surprisingly, their presence is highly discussed among experts and regulators. In general, as they are designed for trading large blocks of securities without being visible to the public, they may benefit the big players at the disadvantage of retail ones.

Degrees of transparency can affect the attractiveness of different exchanges to traders - transparency may include the identity of the (potential) counterparty. Knowing the counterparty’s identity offers insights into their trading motives and the degree of information they have, specifically whether they have superior information about the security value. Knowing the motivations of trading, liquidity suppliers can offer different prices to different traders, incurring price discrimination.

Indeed, large visible orders are proven to produce an adverse price reaction in the market, playing against large traders themselves; that’s the main reason why dark pools are used, for the reduction of market impact in block trading. Large investors don’t like their trading intentions to be visible, too much transparency does not benefit block investors, but dark markets can help them by lowering the market impact and the adverse price reaction.

Moreover, large players can have their big orders matched by the pool at more favourable prices with respect to public ones; a big disadvantage for retail and small investors suffering from the divergence between the prices at which dark pools trade and the execution price in public exchanges. However, when traders transact in the dark, despite the price improvement, they face non-execution risks. And this trade-off is crucial in determining the order flow to dark pools. Thanks to active and effective monitoring, and technological improvements (which are certainly more advanced in the dark than in public exchanges), these venues are growing in reliability.

Another point in favour to the dark is that unwanted price volatility is lowered by a certain level of anonymity, since information about orders is not given to competitors, who cannot push prices against others through their trades. Finally, lower transaction costs are associated with dark pools, since they eliminate the cost of routing orders to external markets.

The Downsides Of Dark Pools

Within dark pools possible abuses may arise, such as front running (illegal and unethical trading using inside information that has not yet been made public) or pinging by HFT traders (by sending out multiple small “ping” orders for trades, HFTs can use these like a sonar to detect when institutional investors are going to make large trades in futures contracts. The HFT firm can then jump in front of the institutional investor, buying up the liquidity and selling it back at a higher prices). The lack of fair access to dark pools can also exclude traders who need to access liquidity and leads to opportunity costs.

Public, lit markets, suffer from the presence of dark pools, due to the free-ridden price used in the dark, which usually use the NBBO as a reference, as well as the loss of orders as some traders shift to these competitors: A perfect market sees all available information embedded in the price of securities, and a power market works and acts very fast in incorporating the news in prices; speed and accuracy in doing this feature in the price discovery process. In this context, dark pools may have a negative effect on market stability and price efficiency, as they reduce the available information for a good price discovery process. Volatility and uncertainty arising from a bad price discovery hurts all traders resulting in more market instability and poor identifiable trading opportunities. Price-relevant information for traders are heterogeneous, so dark pools are generally used to mitigate the information risk affecting informed traders.

There is an amplification effect on price discovery due to the presence of dark pools. When there is a low information risk, with high information precision, traders will prefer public exchanges rather than dark ones, leading to a concentration of price-relevant information into the exchange, enhancing price discovery.

As dark pools grow and handle a larger proportion of all orders, the loss of price discovery becomes greater, and prices that can be derived from the available information are less representative of the true prices of securities – driving more traders to dark pools. Consequently, traders are less incentivized to submit their orders in public venues: the lack of accurate prices in the market hurts resource allocation and efficiency.

A Fragmented Scenario

Dark pools, each with its own rules, risk fragmentation of information. Although market fragmentation may be beneficial by enhancing competition among markets, liquidity and information fragmentation rise concerns particularly about the research and exclusivity of information for traders.

The loss of price discovery, mentioned in the preceding section, hinders traders’ ability to make decisions, so they compensate by seeking more information; this search is hindered due to fragmentation in both liquidity and information: the costs for information on prices and different pools’ rules are significant, and traders seeking to avoid them may take improper and uninformed decisions. In other words, as search costs increase, market efficiency decreases.

The Transparency Paradox

The factor of the speed with which a trader can enter and exit from an investment, combined with the transaction costs is what we call liquidity in markets; and providing liquidity is the main objective of exchanges. Notwithstanding the fact that transparency enhances market liquidity (at least as far as uninformed traders are concerned), most real-world securities markets are opaque. The reason for this, is that markets structures are designed to the advantage of informed traders and market makers, not to benefit uninformed members of the public or retail traders. To this end an incentive to offer greater opacity to large trades, even though it may lead to a decrease in overall liquidity, still exists.

Too much transparency may expose limit-order placers to a very high risk of being picked off by more informed traders, therefore reducing liquidity and affecting economic efficiency. Complete transparency harms liquidity! Moreover, collusive agreements are more difficult for market makers in opaque markets. This could be a reason why, in a sense, opacity may foster competition between market makers: the detection of violations of the rules would be harder.

In general, advocates for dark trading venues claim that they boost market liquidity while lowering risk, while critics claim that their lack of transparency leaves them open to predatory practices. What happens in practice is a two-tier market: large trades are executed opaquely, small trades transparently. Opaque market makers compete aggressively but only for large orders, while small trades will be filled in transparent markets, since they are unlikely to be informative. The point is, large orders move the market and going into the dark helps minimizing the footprint, resulting in better execution quality. It’s less risky for block traders than going to an exchange, and it usually gets a better outcome.

The Bright Side Of Opacity

Market professionals’ self-interest explains the presence (and the prevalence) of opaque trading systems. Even the most transparent venues allow for some forms of opaque orders, like icebergs in lit markets for avoiding the disclosure of too much information when placing orders - no different from the idea of opacity which informed large traders like.

The alternative to a hidden order for uninformed traders is a market order, but this would lessen Limit Order Book depth, reducing market liquidity. So it looks like anonymity may enhance liquidity after all.