Experts generally agree that dark pools play a critical role in today's marketplace, since they enable participants to freely trade large blocks of stock without alerting the competition and causing abrupt movements in the price of securities. These dark venues include buy-side or broker-operated crossing networks, off-exchange platforms such as ITG's Posit and Goldman Sachs' Sigma X, and internalization engines.
But allowing too much liquidity to flow into the dark, particularly trades that could easily be transacted on a lit market, can actually widen spreads and drive up trading costs on public exchanges, a recent study warns. And since too much dark liquidity will make it more expensive for buyers and sellers to find each other on subsequently less-liquid exchanges, trading volumes that are already meager to begin with will continue to weaken, the study adds.
According to a mathematical model designed for the Australian market, if 20 percent of trading moves into the dark, transaction costs on exchanges will climb nearly one basis point -- or nearly three times the Australian Securities Exchange's round-trip exchange fee of 0.3 basis points. The model was constructed by Alex Frino, the chief executive of the Sydney-based Capital Markets Co-operative Research Centre, who says it is applicable to smaller markets, such as Canada and Singapore.
But the model also is relevant to the U.S. marketplace, Frino argues, and it confirms a 2011 report by Rutgers University professor Dan Weaver. Weaver, whose study was commissioned by NYSE Euronext, concluded that the more a particular stock is traded off- exchange, the wider its spread will be, which makes it more expensive to transact. (NYSE Euronext was recently granted permission by the Securities and Exchange Commission to launch its own dark pool.)
"There are a couple of competing arguments in the U.S. -- one is that dark pools provide competition to lit markets and spreads could narrow," says Frino, who is also a finance professor at the University of Sydney Business School. "Or if they fragment lit markets, they cause spreads to widen. When Weaver came into this area and did this work, it was a pretty open issue. He found that in fact, dark liquidity increased transaction costs. The replication of that study in Australia confirms that for this market as well."
Frino asserts that while most estimates indicate that 30 percent of all U.S. trading occurs in the dark, a Nasdaq official told him in June that the level of dark pool trading among the nation's smaller stocks is actually 50 percent. Meanwhile, Weaver's report for NYSE Euronext suggests that the spreads on those stocks are much higher than they need to be.
The NYSE Euronext report -- which was published in April 2010 and updated last July -- contends that if the off-exchange trading of a security that has 40 percent of its volume transacted in dark pools were to be eliminated, its spread would narrow by 3 cents. The Capital Markets Co-operative Research Centre's Frino, however, concedes that since the U.S. markets are much larger and more liquid than the Australian market, its securities are better equipped to handle such fragmentation than their counterparts Down Under.
"The U.S. markets are the most deep and liquid in the world, so fragmenting liquidity will have less of an impact in the U.S. than it would in the Australian market or the Canadian market, which are relatively illiquid," Frino says. "Just to give you an idea, the top five stocks on the Nasdaq turned over last year to the order of $3 trillion. That's three times the turnover of the entire Australian market."