“Dark Pools” can improve price discovery in open exchanges

When big investors want to execute trades but fear the size of the transaction could move the market, they often go to dark pools—alternative trading systems where orders are not publicly displayed. These opaque trading venues, now accounting for about 12 percent of equity trading volume in the United States, have sparked concern among regulators and in the financial press. With so many transactions occurring out of public view, critics warn that price discovery, the accurate determination of asset prices, will become more difficult.

Professor Haoxiang Zhu

But despite their sinister sounding name, dark pools can actually improve price discovery in open exchanges, I have found in my research, “Do dark pools harm price discovery?” Open a dark pool alongside a ‘lit’ pool, such as the New York Stock Exchange or Nasdaq, where orders are visible to all, and pricing can become more accurate on the open exchange.

To understand why this happens, it helps to consider investors to be divided loosely into two groups: informed and uninformed. Informed investors examine balance sheets, study analyst reports, read company press releases, and use advanced technology to monitor the market. When informed investors decide to execute a trade, they hope to profit from the information they gathered–and quickly.

Uninformed investors trade mainly for liquidity reasons. They may need to get cash to meet an obligation, or they may have cash they need to invest. They want to make their transaction regardless of a company’s fundamentals.

A dark pool presents different execution risks to informed and uninformed investors. This risk arises because a dark pool relies on matching, rather market makers, to execute trades. For example, if a dark pool has 300 shares to buy and 200 shares to sell, then only two thirds of each buy order is executed. Failure of execution is costly. (On an open exchange, those extra 100 shares to buy would be executed by market makers or liquidity providers). Informed investors have a high execution risk in the dark pool because they tend to trade in the same direction. Uninformed traders have a lower execution risk because their orders tend to be balanced on either side of the market.

This difference in execution risk tends to drive a greater proportion of informed investors to the open exchange and a larger share of uninformed investors to the dark pool. Having more informed investors trading on an exchange improves price discovery in the exchange and yield more accurate asset prices—precisely the opposite of what critics of dark pools fear.

While having non-displayed orders can help price discovery, dark pools are opaque in other, potentially harmful, ways. For example, dark pools typically do not disclose how they operate, and investors and the public often don’t know how the venues set execution prices or process orders. Increased oversight and closer scrutiny of dark pools could well be a very good thing for financial markets. But not displaying orders in itself needs not threaten price discovery in transparent venues. Instead, it could help.

Haoxiang  Zhu is Assistant Professor of Finance at the MIT Sloan School of Management