The dark side of dark pools: higher trading costs?
First Published 27th June 2012
A study by Professor Alex Frino suggests dark pools can make it costlier for buyers and sellers to find each other in certain markets.
Professor Alex Frino
"The debate about the sins and virtues of different types of dark liquidity is yet to begin. But it's one that regulators - and indeed investors - should be very interested in."
Sydney - Dark pools can increase trading costs dramatically in some smaller markets compared with lit trading, according to a study by Professor Alex Frino of the University of Sydney Business School.
Professor Frino, who also recently released a study showing the beneficial effects of high-frequency trading, created a time-seris model that looked at bid-ask spreads relative to volume when trading moved from lit markets to dark pools. He designed it for the Australian market but said it is applicable to other small markets with fast trading technology, such as Canada and Singapore.
According to Frino's model, if 20% of trading moves into the dark, it will increase trading costs on the lit exchange by almost 1 basis point, which is many times more than the round trip ASX fee of 0.3 basis point.
"When trading moves off-exchange, trading costs on the lit exchange rise and it becomes more costly for buyers and sellers to find each other" Frino said. "This implies that dark liquidity has a significant negative impact on liquidity, and on price discovery."
Frino's research was particularly focused on smaller markets.
"In big, liquid markets like the US, or even Japan, moving some trading off-exchange may make little difference," he said. "There, where the top five stocks on NASDAQ trade five times the volume of the whole Australian market every day, taking a portion of that trading activity away isn't that meaningful for trading costs and volumes. But in Australia or Singapore it's a very different story because volumes and liquidity are low to begin with."
Frino added: "We're seeing markets fragment in Asia as we did years ago in the US and Europe," he said. "The issue is that some Asian markets aren't big enough to handle it. Pulling liquidity off the lit exchanges, and the subsequent increase in trading costs, only further injures already struggling volumes."
While claims are often made about dark pools hurting retail investors, Frino cautioned against drawing simplistic conclusions.
"On the face of it, it makes sense to assume that retail investors suffer most from these kinds of impacts," he said. "But the fact is that a huge percentage of retail money is invested via institutions, so what's good for institutional investors is good for retail investors overall."
He also noted there are different types of dark pools: broker crossing networks, buy-side crossing networks, internalisers where client flow is crossed against the broker's own flow, venue dark pools and dark orders on lit order books such as iceberg orders.
"The debate about the sins and virtues of different types of dark liquidity is yet to begin," he said. "But it's one that regulators - and indeed investors - should be very interested in."