Should we be afraid of the dark? Dark trading and market quality

Abstract

Growth in trading without pre-trade transparency, ‘dark trading’, has caused considerable concern among regulators and exchanges worldwide about its impact on market quality. These concerns recently prompted Canadian regulators to implement novel restrictions on dark trading. We exploit this natural experiment, which reduced the level of dark trading by more than one third literally overnight, together with proprietary trade-level data from dark trading venues to examine the impact of dark trading on liquidity and informational efficiency. We find that low levels of dark trading, as exist in Canada, are largely beneficial, reducing quoted, effective and realized spreads and increasing informational efficiency. Our results are consistent with the notion that, to a point, dark trading increases competition among informed traders who seek to capture rents from liquidity provision while minimizing leakage of their information. We do not find any evidence that the Canadian restrictions caused migration of dark trading to the US in cross-listed stocks