Dangers and benefits of too much dark liquidity


A few recent studies have concluded that as equity volume migrates to dark pools, transactions costs rise.

Advanced Trading notes a study by Alex Frino, the chief executive of the Sydney-based Capital Markets Co-operative Research Centre, who found that if 20 percent of trading moves to dark venues, transaction costs on exchanges will climb nearly one basis point. A study done by Rutgers University academics found that rising dark pool volume is correlated with rising spreads.

There was a time when this would have been an unquestioned negative, but when it comes to small stocks---and Frino has been told that 50 percent of small stock volume is handled in the dark---widening spreads may not necessarily be a terrible thing. In some quarters, the whole idea of best execution is start to morph just a bit, as people realize that spreads and commissions certainly matter in terms of long-term liquidity.

While the higher costs are born by investors, there will be some trickle down effects down to the traditional market makers and liquidity takers. No wants to see the price discovery function deteriorate, and that may not necessarily happen in large markets, even with a lot of dark pool volume.

"Our displayed markets -- and to some extent dark pools -- are connected through regulation and technology, which mitigates the dangers of price discovery deterioration.  That said, that connectivity is far from perfect and, for the less-liquid stocks, for which there actually is more off-exchange activity generally speaking, the issue is likely exacerbated," one expert was quoted.

For these stocks, the focus seems to be shifting a bit from best execution solely to best execution with an eye on improving liquidity, which has been a casualty of the modern markets. 

For more:
- here's the article

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