Understanding the Impacts of Dark Pools on Price Discovery

Abstract

This paper investigates the impact of dark pools on price discovery (the efficiency of prices on stock exchanges to aggregate information). Assets are traded in either an exchange or a dark pool, with the dark pool offering better prices but lower execution rates. Informed traders receive noisy and heterogeneous signals about an asset’s fundamental. We find that informed traders use dark pools to mitigate their information risk and there is a sorting effect: in equilibrium, traders with strong signals trade in exchanges, traders with moderate signals trade in dark pools, and traders with weak signals do not trade. As a result, dark pools have an amplification effect on price discovery. That is, when information precision is high (information risk is low), the majority of informed traders trade in the exchange hence adding a dark pool enhances price discovery, whereas when information precision is low (information risk is high), the majority of the informed traders trade in the dark pool hence adding a dark pool impairs price discovery. The paper reconciles the conflicting empirical evidence and produces novel empirical predictions. The paper also provides regulatory suggestions with dark pools on current equity markets and in emerging markets.