Dark market fragmentation in U.S. equity markets

Abstract

Recently, there has been widespread concern over the growth of new ‘dark’ trading venues in equity markets. It is important to understand the implications of these changes for market quality and the impact of different trading rules, in respect of dark pools, on the relative competitive positions of trading venues. Compared to exchange trading, dark venues are characterised by pre-trade opacity, exemptions from fair access requirements and the frequent use of sub-penny pricing. This dissertation shows that these unique features influence the ability of new and existing trading venues to compete for order flow and may have long term consequences for market quality.

First, I investigate the role of sub-penny pricing in the competition for order flow between venues that differ on the basis of tick size regimes. I find that order flow migrates to dark venues offering sub-penny pricing when prices are constrained by the minimum 0.01 USD tick size on the exchange. The implication of the finding is that larger minimum tick sizes generally put trading venues at a competitive disadvantage notwithstanding the benefits of discouraging free-riding.

Second, I show that dark venues may use their unique features to attract uninformed clients, resulting in a segregation of informed and uninformed order flow. As a result, dark market fragmentation is associated with lower market quality, evidenced by higher transaction costs and lower price efficiency. However, the execution of large transactions on dark venues does not harm market quality.

Third, I test whether non-displayed limit order books are more attractive to informed traders than crossing networks that cross only at the midpoint because traders can use discretionary pricing to reduce non-execution risk. The results show that trades executed at non-discretionary prices are more informed than trades executed at the midpoint of the National Best Bid and Offer.

This dissertation contributes to the long-standing debate on market fragmentation versus market consolidation. The results also have policy implications for market regulators, who are required by their published mandates to assure themselves before approving market design changes that the changes enhance market quality, taking account of both market efficiency and market integrity.