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Study: Dark pools improve price discovery

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Many would agree that dark pools have contributed to the fragmentation of the current market system and thus have hampered price discovery, to the detriment of retail investors.

This issue will heat up significantly in 2013 as regulators are forced to grapple with thorny market structure issues that could eventually amount to a profound restructuring of the way the modern markets work. Any significant change, or really even small changes, will be preceded by robust debate of course. 

I raise this in light of a recent study by a Sloan School of Management professor who has come to novel conclusion: Dark pools actually enhance price discovery. The assumption behind this is that the market can be divided into two camps: Informed traders, who buy and sell based on proprietary information, and liquidity traders, who are trying to meet specific liquidity needs. They must choose between an exchange and a dark pool.

The study notes, that "Because matching in the dark pool depends on the availability of counterparties, some orders on the 'heavier' side of the market--the side with more orders--will fail to be executed. These unexecuted orders may suffer costly delays. Because informed orders are positively correlated with the value of the asset and therefore with each other, informed orders are more likely to cluster on the heavy side of the market and suffer lower execution probabilities in the dark pool. By contrast, liquidity orders are less correlated with each other and less likely to cluster on the heavy side of the market; thus, liquidity orders have higher execution probabilities in the dark pool. This difference in execution risk pushes relatively more informed traders into the exchange and relatively more uninformed traders into the dark pool. Under natural conditions, this self-selection lowers the noisiness of demand and supply on the exchange and improves price discovery."

The study also points out that it is not making any conclusions about the welfare of the markets. What do you think?

For more:
- here's the study

Related articles:
Exchanges: Dark pool growth hurts investors