Welfare Analysis of Dark Pools

We investigate the role of a class of alternative market structures known as electronic crossing networks or "dark pools". Relative to traditional "lit" markets, dark pools offer investors the trade-off of reduced transaction costs in exchange for greater uncertainty of trade. Our paper studies the welfare implications of operating a dark pool alongside traditional lit markets. We study equilibria of a market with intrinsic traders and speculators, each endowed with heterogeneous fine-grained information, who endogenously choose between dark and lit venues. We establish that while dark pools attract relatively uninformed investors, the orders therein experience an implicit transaction cost in the form of adverse selection. Moreover, the informational segmentation created by a dark pool leads to greater transaction costs in lit markets. Taken together, we establish that there exist reasonable parameter regimes where the introduction of a dark pool decreases the overall welfare of market participants.