Dark Trading Volume and Market Quality: A Natural Experiment

Abstract

We exploit an exogenous shock to dark trading volume to identify the causal effect of changes in dark trading volume on market quality. Following a 34% reduction in dark trading, the cost of trade (e.g. effective spreads, realized spreads, price impact, and quoted spreads) remain unchanged. We also find limited evidence that prices become less efficient. We show that other variables relating to overall trading activity and how trades are dispersed across lit venues change only modestly compared to the shock to dark trading, and we argue that offsetting effects are unlikely to contaminate the experiment. Our main inference differs significantly from prior studies that conclude increases in dark trading negatively affect market quality. We provide robust evidence that differences in inference cannot be attributed to different stock samples or time periods, but rather are the result of different empirical approaches. Our research highlights the benefit of structured experimentation from the Securities and Exchange Commission (SEC) for understanding causal effects in capital markets.