Financial Analysts Journal

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Dark Trading and Equity Market Quality

Rhodri Preece & Sviatoslav Rosov

To cite this article: Rhodri Preece & Sviatoslav Rosov (2014) Dark Trading and Equity Market
Quality, Financial Analysts Journal, 70:6, 33-48, DOI: 10.2469/faj.v70.n6.2

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 Financial Analysts Journal
·
Volume 70 Number 6
©2014 CFA Institute

Dark Trading and Equity Market Quality

Rhodri Preece, CFA, and Sviatoslav Rosov

Off-exchange trading in equity markets, including broker/dealer internalization and dark pools, has grown
in recent years. An examination of the relationship between dark trading and market quality suggests that
as dark trading increases, the marginal benefit from it declines. Beyond a certain threshold, increases in dark
trading may be associated with deteriorating market quality. The level of this threshold is related to the type
of dark trading and the market capitalization of the stock.

O
ver the past decade, the US equity mar-
ket has undergone a significant structural
change driven by the combined forces of
technology, regulation, globalization, and competi-
tion. Trading has become increasingly automated,
fast paced, competitive, and spatially dispersed.
Today, the US equity market is a vast, decentralized
electronic network that depends on technology
to generate and match order flow at great speed.
This evolution has been accompanied by a decrease
in average trade size and a significant increase in
overall quote traffic and transaction volumes.
Trading costs (both bid–ask spreads and com-
missions) have fallen, while liquidity has become
increasingly fragmented over multiple venues. In
particular, the fragmentation of liquidity has been
associated with a significant shift of trading vol-
ume away from the primary listing markets and
toward undisplayed off-exchange trading venues.
For example, between January 2009 and April 2014,
the market shares of NYSE Euronext and NASDAQ
OMX declined by approximately one-third and
one-quarter, respectively, while off-exchange trad-
ing volume increased from one-quarter to more
than one-third of the market (see Table 1).
Off-exchange trading can be broadly catego-
rized into transactions that occur in three ways. First,
transactions can be executed on alternative trading
systems (ATSs), such as electronic communications
networks (ECNs) and dark pools. Second, orders
can be executed via broker/dealer internalization,
which is the systematic internal execution of client
orders against the broker/dealer’s own account.
Internalization—whereby brokerages route retail
order flow to an off-exchange market maker, typically
under payment for order flow arrangements—is the
Rhodri Preece, CFA, is head of capital markets policy,
EMEA, and Sviatoslav Rosov is an analyst in the capital
markets policy group at CFA Institute, London.
dominant trading modality for retail orders in the
United States. Third, irregular or nonsystematic off-
exchange transactions may be simply classified as
“other OTC transactions.” A characteristic common
to dark pool transactions, broker/dealer internaliza-
tion, and other OTC transactions is a limited degree
of pre-trade transparency; orders are not displayed
in the public consolidated quotation system prior
to execution. Consequently, these types of transac-
tions can be considered “dark trading.” In contrast,
on-exchange business is mostly (though not exclu-
sively) pre-trade transparent.
Investors and regulators have raised a num-
ber of concerns about the recent changes in market
structure. First, many perceive a degradation of
market transparency arising from the growth in
dark trading and the corresponding fall in the mar-
ket share of “lit” venues. Second, an uneven playing
field between different types of trading venues and
between different classes of investors in terms of
access to markets can distort competition and fair-
ness. Also, there is a greater potential for systemic
risk propagation resulting from the market’s depen-
dence on automation and its interconnectedness.
A more fundamental concern associated with
the growth in dark trading is that the willingness of
investors to post displayed limit orders—the build-
ing blocks of price discovery—could be harmed
if a significant proportion of orders are filled off
exchange at the expense of the limit order submit-
ter. This scenario could disincentivize investors
from using the lit markets.
To determine whether investors and regulators
are right to be concerned about the developments in
equity market structure, we examined the relation
between dark trading and market quality. We studied
the impact of dark trading on two proxies for market
quality: bid–offer spreads and top-of-book market
depth. The main innovation of our study is the sepa-
ration of dark trading into two components—dark

November/December 2014 www.cfapubs.org 33

Financial Analysts Journal
Table 1.  US Trading Venue Market Shares
Month NYSE Euronext
January 2009 33.3%
May 2012 24.5
April 2014 22.2
Notes: This table presents market share as a percentage of consolidated volume. TRFs are
FINRA Trade Reporting Facilities.
Source: Thomson Reuters Equity Market Share Reporter.
pools and broker/dealer internalization. Other stud-
ies on market fragmentation have not differentiated
among types of dark trading. Further, we build on
existing literature, which identifies both positive
and negative associations between dark trading
and market quality, by examining a nonlinear rela-
tionship. The results of our analysis suggest that an
increase in dark pool activity and internalization is
initially associated with an improvement in market
quality that persists only up to a certain threshold. If
the majority of trading occurs in undisplayed ven-
ues, market quality benefits will disappear and may
actually reverse.
Market Structure
Equity trading in the United States is currently dis-
persed over 13 exchanges, more than 30 dark pools,
and more than 200 broker/dealers that internalize
order flow. Consolidated trade data published by
Thomson Reuters show that exchanges account
for approximately two-thirds of consolidated vol-
ume whereas off-exchange transactions account for
approximately one-third.
Dark Pools. In contrast to exchanges and
ECNs, dark pools operate without pre-trade trans-
parency. Orders are not displayed to other market
participants and are matched anonymously. Many
dark pools do, however, send out indications of
interest (IOIs) to select market participants. These
IOIs may indicate the name of the security, the
number of shares, and the direction of trade but
not the price. The lack of pre-trade transparency
in dark pools allows investors to minimize infor-
mation leakage and market impact costs, which
historically made dark pools particularly attractive
for the execution of large block orders. Today, how-
ever, order and transaction sizes in dark pools are
comparable to those on transparent exchanges (see,
for example, Hatheway, Kwan, and Zheng 2013).
Dark pools may also provide the potential for
price improvement and, more generally, reduced
transaction costs. For example, crossing offsetting
orders at the midpoint of the National Best Bid and
Offer (NBBO) would save the respective counter-
parties from exchange fees and half the bid–offer
34 www.cfapubs.org
Off Exchange
NASDAQ OMX (TRFs)
27.6% 25.6%
22.6 30.1
20.8 35.5
spread. Another potential benefit is that access
to certain dark pools may be limited to specific
counterparties (e.g., clients of the bank that spon-
sors the dark pool or buy-side-only institutions).
Discrimination among counterparties can make it
possible for such clients as institutional investors to
avoid trading with undesired market participants
(e.g., high-frequency trading firms).
Several different types of dark pools oper-
ate in the United States (see, e.g., Zhu 2012), and
they can be classified according to the operator
type (broker/dealer, market maker, or indepen-
dent pool) or by function (block-cross, continuous-
cross, or liquidity-provider platform). Some dark
pools match only customer-to-customer order flow,
whereas others allow customer order flow to exe-
cute against the broker’s own account. Some dark
pool platforms aggregate liquidity from different
pools. Data from Rosenblatt Securities show that in
aggregate, dark pools have accounted for between
approximately 8% and 13% of the consolidated vol-
ume over a recent three-year period.
Broker/Dealer  Internalization. Internaliza-
tion involves broker/dealers acting as over-the-
counter market makers by systematically executing
client order flow against their own accounts.
Internalization represents a form of dark trad-
ing because OTC market makers are not required
to display quotes prior to execution. Further, like
dark pools, these market makers may discriminate
among counterparties when accepting orders.
Broker/dealer internalization represents a sig-
nificant proportion of overall trading activity and
is typically driven by the purchase of order flow by
wholesale OTC market makers from retail broker-
age firms. Retail internalization is also referred to
as “preferencing,” reflecting the fact that the OTC
market maker can discriminate among orders for
internal execution. Because retail investors are
typically less informed than professional or institu-
tional investors, OTC market makers can internal-
ize those retail orders that are on the wrong side
of the market (that is, against the expected direc-
tion of short-term market movements) and route
unwanted orders elsewhere.
©2014 CFA Institute

Broker/dealers have to provide best execu-
tion for their clients, so the prices at which they
internalize orders must match or beat the NBBO.
Because there are no quoting obligations for
internalization, broker/dealers can provide price
improvement to their customers in the form of
sub-penny executions, often at a magnitude of
$0.0001 per share. Although internalization can
provide nominal price improvement, it carries an
opportunity cost for liquidity providers. Investors
who submit passive limit orders on exchanges
assume risk by displaying their trading intentions;
this risk may not be rewarded if the interception
of marketable order flow by OTC market makers
leaves limit orders unfilled or filled only when
they are on the wrong side of the market. This situ-
ation can affect the incentives for liquidity provid-
ers to display quotations.
Trade Reporting. Off-exchange transactions
are reported to one of two main Trade Reporting
Facilities (TRFs) that are registered and overseen
by the Financial Industry Regulatory Authority
(FINRA). NASDAQ operates the largest TRF, the
FINRA/NASDAQ TRF, which accounts for approx-
imately 95% of all off-exchange transactions. NYSE
operates the FINRA/NYSE TRF. All transactions
reported through a TRF are sent to the central data
consolidator (the Securities Information Processor,
or SIP) for inclusion in the consolidated tape.
Literature Review
Research on the relation between dark trading and
market quality has yielded mixed conclusions.
Market quality may decline as the level of
undisplayed trading increases. For example,
Degryse, de Jong, and van Kervel (2011) argued that
the quantity of uninformed order flow preferenced
in dark markets is positively related to the propor-
tion of informed order flow on exchanges. This
phenomenon is known as the “cream-skimming
effect.” Consequently, the adverse selection com-
ponent of the bid–offer spread on exchanges (and
with it, the spread itself) can increase because mar-
ket participants will need to be compensated for
the increased risk of adversely selecting informed
or “toxic” order flow with which to trade (see also
Bagehot 1971; Easley, Kiefer, and O’Hara 1996;
Treepongkaruna, Brailsford, and Gray forthcom-
ing). The results in Weaver (2011) support this
hypothesis; he found larger spreads and lower
depth with increasing undisplayed trading.
Similarly, Hatheway et al. (2013) found evidence
consistent with the cream-skimming effect and
showed that dark venues segregate order flow on
the basis of asymmetric information risk. They
November/December 2014 www.cfapubs.org 35
Dark Trading and Equity Market Quality
argued that order segmentation by dark venues
is damaging to overall market quality (increases
adverse selection costs) except in the case of exe-
cuting large transactions.
Comerton-Forde and Putnins (2012) provided
further detail on the cream-skimming hypoth-
esis and posited that trades that migrate to dark
exchanges are less informed than those left behind
on lit exchanges. Therefore, in addition to increased
adverse selection costs on lit exchanges, the authors
expected a deterioration in price discovery as well.
Their results were consistent with this hypothesis,
showing that informational efficiency begins to
decline once dark trading exceeds 10% of volume
in dollar terms.
Although the cream-skimming hypothesis
may be intuitive, Chung, Chuwonganant, and
McCormick (2006) noted that brokers are likely to
charge uninformed traders a lower commission as
compensation for the higher spread. If lower com-
missions reduce the execution costs of uninformed
traders, the net effect of order preferencing on over-
all execution quality can be positive. Chung et al.
(2006) showed that brokers selectively internalize
orders on the basis of their information content
but that this order preferencing is not necessarily
harmful. Hansch, Naik, and Viswanathan (1999)
and Peterson and Sirri (2003) found similarly
benign impacts, whereas O’Hara and Ye (2011) and
Buti, Rindi, and Werner (2010) revealed a positive
relation between dark trading and market quality.
O’Hara and Ye (2011) found that more fragmented
stocks with higher levels of off-exchange trading
are associated with lower transaction costs. Buti
et al. (2010) investigated a sample of 11 dark pools
and found that as dark pool activity increases,
quoted and effective spreads narrow, price impacts
decrease, and volatility declines.
Significantly, previous researchers (with the
exception of Buti et al. 2010) have not explicitly
distinguished between different types of off-
exchange trading, which limits the usefulness of
their findings for public policy. Absent an analysis
of both dark pools and broker/dealer internaliza-
tion within the same sample, it is not clear which
type of dark trading drives the observed effects
or whether the two trading modalities yield simi-
lar effects with regard to liquidity and market
quality. Our sample includes both broker/dealer
internalization and dark pool data, so we are able
to provide a more nuanced view on dark trading.
Specifically, the literature provides evidence that
dark trading has both positive effects on mar-
ket quality (from increased competition or frag-
mentation) and negative effects (from increased
adverse selection). Therefore, it is possible that
Financial Analysts Journal
dark trading has a cost–benefit trade-off that
could result in a nonlinear relation with market
quality. We tested this hypothesis by examining
a quadratic relation between the two types of
dark trading and market quality. We posit that the
competition induced by dark trading is initially
beneficial for market quality but that if it domi-
nates, these benefits are negated by the increased
adverse selection risk on exchanges, which may
cause liquidity to deteriorate.
Data
Our dataset is a sample of 450 stocks stratified by
listing market and market capitalization. To obtain
our sample, we first selected the universe of securi-
ties listed on NYSE (including NYSE Arca), NYSE
MKT, and NASDAQ using data from FactSet. We
then screened for only US common stocks, exclud-
ing any inactive securities or secondary listings.
We also removed significant outliers (following
Weaver 2011), including particularly high-priced
stocks (those that closed above $500 in the review
period), low-priced stocks (those that never closed
above $5 in the review period), and low-volume
stocks (those with average daily volume of fewer
than 1,000 shares). This screening process resulted
in a population of 2,350 stocks.
Next, we classified stocks according to mar-
ket capitalization using the following parameters:
small cap < $1 billion, mid-cap ≥ $1 billion but
< $5 billion, and large cap ≥ $5 billion. We then
sought to obtain a sample of 150 stocks from each
market-capitalization category (providing a total
of 450 stocks).
For the large-cap sample, there were no large-
cap stocks listed on NYSE MKT (formerly the
Amex) in our screened population and only 59 such
stocks listed on NASDAQ. Therefore, we selected
all 59 large-cap NASDAQ stocks and randomly
selected the balance of 91 from the NYSE-listed
large-cap stocks in the screened population. To
obtain our mid-cap sample, we selected all four
mid-cap stocks listed on NYSE MKT in the screened
population, along with 73 randomly selected mid-
cap stocks from NASDAQ and 73 from NYSE. For
the small-cap sample, 50 small-cap stocks were
randomly selected from each listing market in the
screened population.
For each stock, data on market quality measures
and off-exchange volumes were obtained for the
second, third, fourth, fifth, and sixth Wednesdays of
each quarter from the first quarter of 2009 through
the second quarter of 2011, resulting in a panel of
observations on 450 stocks across 50 dates.
36 www.cfapubs.org
The period under review was a time of rela-
tive stability in the equity markets, following the
acute phase of the financial crisis in the second
half of 2008. The selection of this time period
should have minimized any systemic effects that
may have influenced the data. Furthermore, the
time span also reflects a period when the equity
market had already fragmented significantly and
high-frequency trading (HFT) was well estab-
lished. These considerations should make it less
likely that the results are affected by a structural
change in the review period.
Data for the following variables were obtained
from NASDAQ for each stock:
Quoted spread in dollars,
Relative spread in basis points, and
Average quoted depth, calculated as the aver-
age of the average ask size and average bid size
at the top of the order book across all venues
displaying quotes at the NBBO (depth is mea-
sured in share terms and in dollar terms).
Duration-weighted averages were then calcu-
lated for day t on the basis of the length of time that
the quote was at the NBBO. The quoted spread,
relative spread, and average top-of-book depth are
the market quality measures that we examined.
We also collected data on other variables,
including volatility (standard deviation of daily
returns and daily range scaled by closing price),
closing price, market capitalization, number of
quote updates, number of trades, total consoli-
dated volume, total volume reported to the NYSE
TRF, volume reported to the NASDAQ TRF from
firms associated primarily with dark pools, vol-
ume reported to the NASDAQ TRF from firms
associated primarily with retail internalization,
volume of other OTC transactions reported to
the NASDAQ TRF, and volume of technical
trades (nonaddressable liquidity) reported to the
NASDAQ TRF.
As this list suggests, dark trading reported
through the NASDAQ TRF (accounting for
approximately 95% of all off-exchange trading
in our sample) was subcategorized by NASDAQ
using information on the identity of the party
reporting a given trade. Several dark pools
report trades using their own unique reporting
identifier, so they can be positively identified
and aggregated. But in cases in which a unique
reporting identifier is not used, the classification
was based on knowledge of the type of activity
that a given participant’s reporting identifier is
most typically associated with. To validate the
accuracy of this judgment, we compared the ratio
of dark pool volume to total off-exchange volume
in our sample with the figures reported in the US
©2014 CFA Institute
 Dark Trading and Equity Market Quality

SEC’s concept release on equity market struc-
ture (SEC 2010). For our total sample, the aver-
age dark pool volume (7%) accounts for 30% of
total off-exchange volume, which is comparable
with the figure of 31% obtained from the SEC.
This similarity suggests that there are no material
classification errors for dark pools and other off-
exchange volume in our data.
A second caveat is that ECNs, which are dis-
played venues, also report trades through TRFs.
Consequently, to minimize the presence of dis-
played liquidity within our TRF data, trades from
Direct Edge, the largest ECN prior to its conversion
to an exchange in July 2010, have been removed.
After July 2010, this adjustment is unnecessary.
Matched order flow on the remaining ECNs is esti-
mated to account for less than 1% of consolidated
volume. Consequently, any remaining “lit” volume
within the TRF data is immaterial and should not
affect the results.
Finally, we removed any clearly erroneous
data, including stocks with quoted spreads or rela-
tive spreads that were negative, greater than $10, or
greater than 5,000 bps. Similarly, any observations
for which total off-exchange volume exceeded total
consolidated volume were removed.
Descriptive Statistics
Descriptive statistics are presented in Table 2,
which shows that the mean dollar quoted spread
for the total sample is 11 cents. The mean quoted
spread for small-cap stocks (29 cents) is much
higher than that for large-cap stocks (2 cents), as
one might expect given their relative riskiness.
The same is true for relative spreads; the mean is
255 bps for small caps and 5 bps for large caps. The
small-cap spread data are skewed; the median rel-
ative spread is 83 bps. This skew reflects the very
high spreads charged for highly illiquid small-cap
stocks. To address this issue, we removed several
outliers and took log transformations of the mar-
ket quality variables.
Similarly, average top-of-book depth (in shares
and in dollars) is significantly higher for large caps
than for small caps. This result reflects the willing-
ness of market makers to quote in relatively large
sizes for larger, more liquid stocks, which have
greater breadth of trading interest. Median depth

Table 2.  Descriptive Statistics

Full Sample Small Cap Medium Cap Large Cap
Quoted spread ($)
Mean 0.11 0.29 0.05 0.02
Median 0.02 0.09 0.02 0.01
Standard deviation 0.36 0.6 0.17 0.03

Relative spread (bps)

Mean 79.95 254.59 13.29 5.47
Median 8.67 83.49 9.14 4.11
Standard deviation 243.25 396.9 43.05 48.97

Depth (shares)
Mean 5,362 908 4,207 10,128
Median 818 454 751 1,663
Standard deviation 21,375 1,518 12,956 32,788

Depth ($)
Mean 219,613 8,611 414,561 194,736
Median 24,289 5,964 21,393 66,905
Standard deviation 14,900,000 30,822 24,900,000 1,774,293

Quote updates
Mean 181,816 20,261 120,711 373,933
Median 92,690 3,865 81,321 267,286
Standard deviation 263,139 41,855 128,887 339,013

Number of trades
Mean 16,168 887 8,795 35,939
Median 5,727 84 4,781 20,163
Standard deviation 36,159 2,190 13,395 53,480
(continued)

November/December 2014 www.cfapubs.org 37

Financial Analysts Journal

Table 2.  Descriptive Statistics (continued)

Full Sample Small Cap Medium Cap Large Cap
Quote-to-trade ratio
Mean 49.4 108.5 37.4 13.7
Median 16 29.3 16.9 12.4
Standard deviation 1,239.90 2,247.80 479.9 6.3

Average trade size (share volume/number of trades)

Mean 198 213 178 204
Median 167 162 159 178
Standard deviation 270 485 66 96

Proportion of off-exchange volume

Mean 0.23 0.27 0.22 0.22
Median 0.21 0.23 0.21 0.21
Standard deviation 0.14 0.23 0.1 0.08

Proportion of NYSE TRF volume

Mean 0.01 0.01 0.02 0.02
Median 0.01 0 0.01 0.01
Standard deviation 0.02 0.02 0.02 0.02

Proportion of dark pool volume

Mean 0.07 0.03 0.08 0.08
Median 0.06 0.01 0.07 0.07
Standard deviation 0.06 0.06 0.06 0.04

Proportion of internalized volume

Mean 0.1 0.19 0.07 0.07
Median 0.06 0.12 0.06 0.06
Standard deviation 0.13 0.21 0.05 0.04

Proportion of other OTC volume

Mean 0.05 0.04 0.05 0.05
Median 0.03 0.01 0.03 0.04
Standard deviation 0.08 0.11 0.06 0.05
Notes: This table shows descriptive statistics by market-capitalization subsample. The full sample contains 450 stocks, and
there are 150 stocks in each of the small-cap (< $1 billion), medium-cap ($1 billion–$5 billion), and large-cap (> $5 billion)
buckets.

for large-cap stocks is 1,663 shares or $66,905,
compared with 454 shares or $5,964 for small-
cap stocks. Both volatility measures have similar
means and medians. Average volatility is higher
among small caps than among large caps, which is
again consistent with expectations.
The number of quote updates and the quote-
to-trade ratio can be considered proxies for
algorithmic trading intensity. “Algo” trading is
consistent with a high volume of message traf-
fic whereby orders are entered, modified, and
canceled rapidly in response to changing market
conditions. The median number of quote updates
to the best bid or best offer per stock per day is
267,286 for large caps and 3,865 for small caps,
which reflects the higher level of trading interest
in large-cap stocks. However, the quote-to-trade
ratio is higher for small caps (median of 29) than
for large caps (median of 12). This result is driven
by fewer daily trades for small caps (median
trade count of 84) than for large caps (median
trade count of 20,163).
We approximated the average trade size for
each stock by dividing the daily consolidated
share volume by the daily number of trades. The
average trade size is similar for the three market-
capitalization subsamples. The median average
trade size is 178 shares for large caps and 162

38 www.cfapubs.org ©2014 CFA Institute


shares for small caps. These trade sizes are low by
historical standards and reflect the pervasive use
of algos and child orders to execute transactions.
The average trade size was relatively stable over
the study period.
The mean total proportion of off-exchange
volume is 23% for the total sample, which seems
reasonable compared with off-exchange volume
figures commonly reported over the period. There
is not much variation among the subsamples,
with off-exchange volume proportions of 27%
for the small-cap sample and 22% for both the
mid- and large-cap samples. In contrast, there is
greater variation among the subsamples for the
proportions of dark pool volume and internalized
volume. Large- and medium-capitalization com-
panies experience relatively higher proportions of
dark pool activity (an average 8% of consolidated
volume for each, compared with just 3% for small
caps), whereas small caps have a relatively higher
proportion of internalized volume (an average
of 19%, compared with 7% for large caps and
medium caps).
It is not surprising that internalization is high-
est for small-cap stocks. Multiple third-party trad-
ing interest in small-cap stocks is relatively low;
thus, investors are relatively more reliant on mar-
ket makers (dealer capital) to execute transactions
in these stocks. The likely reason that small-cap
stocks trade less in dark pools compared with
large- and mid-cap stocks is that their probability
of execution is relatively lower (vis-à-vis large and
medium caps) in dark pools.
Figure 1.  Bid–Offer Spread
Basis Points
200
150
100
50
0
1/Jan/09 1/Jul/09 1/Jan/10
Large
Note: This figure plots the median relative bid–offer spread across the large-, medium-, and small-
cap subsamples over time.
November/December 2014 www.cfapubs.org 39
Dark Trading and Equity Market Quality
It is also important to note the range of dark
trading proportions in our sample. The majority
of the observations of dark pool and internal-
ized trades lie within the 0%–40% market share
range (i.e., dark volume for an individual stock
as a proportion of consolidated volume for that
stock). There are relatively few dark trading
observations in excess of 60%; specifically, there
are 163 observations of stocks with internalized
volumes between 60% and 80% and 143 observa-
tions of stocks with dark volumes between 80%
and 100%.
Figure 1 plots the median relative bid–offer
spreads for the respective samples at each date in
the review period. The trend is downward sloping
for each subsample (it is less pronounced for large-
and mid-cap stocks because of scaling). Relative
bid–offer spreads for both large- and small-cap
stocks declined by approximately 50% over the
period. The dollar quoted spread (not shown)
exhibits a similar pattern, albeit with a shallower
trend than that of the relative spread.
Top-of-book depth is illustrated in Figure 2,
which plots depth in dollars over time for the
median stock in the relevant subsample. Dollar
depth is slightly upward sloping in each sub-
sample, although the pattern is not consistent
over the review period. Depth in shares (not
shown) is relatively flat over the period for each
subsample.
Figure 3 and Figure 4 plot the median market
shares of internalization and dark pools for the
respective subsamples over the review period.
1/Jul/10 1/Jan/11 1/Jul/11
Medium Small
Financial Analysts Journal

These figures show growth in undisplayed trading is greater for small-cap stocks than for large- and
for all stocks, which is unchecked except during the medium-cap stocks, whereas the opposite is true
middle of 2010.1 As noted earlier, internalization for dark pools.

Figure 2.  Dollar Depth

Depth ($)
150,000

100,000

50,000

0
1/Jan/09 1/Jul/09 1/Jan/10 1/Jul/10 1/Jan/11 1/Jul/11
Large Medium Small

Note: This figure plots the median top-of-book dollar depth across the large-, medium-, and small-cap
subsamples over time.

Figure 3.  Proportion of Internalization

Percentage of Total Volume
20

15

10

0
1/Jan/09 1/Jul/09 1/Jan/10 1/Jul/10 1/Jan/11 1/Jul/11
Large Medium Small

Note: This figure plots the median proportion of internalization (market share) across the large-,
medium-, and small-cap subsamples over time.

40 www.cfapubs.org ©2014 CFA Institute


Figure 4.  Proportion of Dark Pool Volume
Percentage of Total Volume
10
0
1/Jan/09 1/Jul/09 1/Jan/10
Large
Note: This figure plots the median proportion of dark pool volume (market share) across the large-,
medium-, and small-cap subsamples over time.
Analysis
In this section, we test the null hypothesis that there
is no relation between the proportions of dark trad-
ing and market quality. The regression model con-
trols for variables known to affect market quality.
First, we controlled for information-based volatil-
ity, which we measured as the natural logarithm
of the standard deviation of daily returns over the
month up to date t. Such information-based volatil-
ity is believed to appropriately influence liquidity.2
Stocks with higher volatility are expected to exhibit
lower liquidity (wider spreads and lower depth). We
also included as control variables the logarithms of
market capitalization and price (hereafter, “market
capitalization” and “price,” respectively). Market
capitalization controls for the fact that larger com-
panies are more heavily traded and, hence, exhibit
higher liquidity. The price level is a scaling factor
and controls for two effects. First, stocks with higher
price levels have higher quoted spreads (to normal-
ize the spread per dollar). Second, the tick size is
constrained to 1 cent for all stocks priced above $1,
which includes all stocks in our sample. For some
very liquid, low-priced stocks, the spread often
equates to the minimum tick size. In this case, vari-
ability in the relative spread could be driven mainly
by changes in the price level (such that the relative
spread increases as the price level decreases), so we
must control for this effect.
The explanatory variables of interest are the pro-
portions of dark pool volume and internalized vol-
ume and their respective squares. This specification
November/December 2014 www.cfapubs.org 41
Dark Trading and Equity Market Quality
1/Jul/10 1/Jan/11 1/Jul/11
Medium Small
allowed us to examine the existence of a nonlinear
(quadratic) relationship. The dependent variables
are three market quality measures: quoted bid–offer
spread, relative bid–offer spread, and average top-of-
book dollar depth. Each variable contains observa-
tions for each stock on each date. We took the natural
logarithms of the dependent variables (as well as the
control variables) to mitigate the skewness of these
variables. Because we used panel data, we estimated
the regression using fixed stock effects to capture
within-stock variation across time (see, for example,
Palkar and Wilcox 2009 and Quan and Titman 1997).
We estimated a separate regression model for each
market quality measure as the dependent variable,
with the general form being
( )
ln MQi ,t = α + β1 ln(σi ,t ) + β2 ln(mkt_capi ,t )
+ β3 ln(pricei ,t )
+ β4 (%internali ,t ) + β5 (%internali ,t )2 (1)
+ β6 (%dark_pooli ,t )
+ β7 (%dark_pooli ,t )2 + εi ,t ,
where for stock i on day t,
    MQi,t  =  the market quality measure (quoted
       spread, relative spread, or dollar
       depth)
       σi,t =  
the standard deviation of daily
   price changes
mkt_capi,t =  the market capitalization
 pricei,t =  the closing price
Financial Analysts Journal

   %internali,t  =    internalized  volume  as  a  pro-
   portion of consolidated volume
%dark_pooli,t =   dark pool volume as a propor-
tion of consolidated volume
Results.  The regression results are presented in
Tables 3–6. At the outset, we did not expect multi-
collinearity to be a problem because the correlations
between the independent and control variables are
mostly lower than 0.1, with the highest individual
correlation being 0.35. For the full sample (Table 3),
the coefficients for the control variables all exhibit
the expected signs with respect to quoted bid–offer
spreads, relative bid–offer spreads, and dollar
depth. Because the control variables and dependent
variables are log transformed, we can interpret the
coefficients easily in terms of percentage changes.
Specifically, Table 3 shows that a 10% increase in
volatility will increase spreads by around 2.3% and
reduce depth (the average dollar size available at the
best bid or best offer) by around 2.1%. A 10% increase
in market capitalization is associated with an approx-
imately 3.2% decrease in spreads and a 4.1% increase
in depth; in other words, larger companies exhibit
higher liquidity. The price level also exhibits the
expected relation with respect to bid–offer spreads.
First, a 10% increase in the price level increases the
quoted spread by 7.8%. Second, a 10% decrease in
the price level increases the relative spread by 2.1%,
an effect that is likely being driven by the quoted
spread converging to the minimum tick size at low
price levels. The price level is not, however, statisti-
cally significantly related to dollar depth.
The coefficients for %internal and %dark_pool
cannot be so easily interpreted owing to the qua-
dratic terms in the regression. Table 3 shows that
the relation between the dark trading variables
and the two spread measures is negative, indicat-
ing that spreads initially decrease as dark trading
increases. Analogously, depth initially increases as
the proportions of internalization and dark pool
activity increase. However, the squared terms carry
the opposite signs to their linear counterparts,
which suggests that the rate at which dark trading
is associated with improving market quality falls

Table 3.  Full Sample Regression Results

ln(Quoted Spread) ln(Relative Spread) ln(Dollar Depth)
Constant 1.88** 11.26*** 0.67
(0.94) (0.96) (2.12)
ln(σ) 0.23*** 0.24*** –0.21***
(0.01) (0.01) (0.02)
ln(mkt_cap) –0.32*** –0.33*** 0.41***
(0.05) (0.05) (0.12)
ln(price) 0.78*** –0.21*** –0.07
(0.05) (0.05) (0.13)
%internal –0.54*** –0.57*** 0.49***
(0.10) (0.10) (0.13)
(%internal)2 0.61*** 0.66*** –0.38**
(0.13) (0.12) (0.16)
%dark_pool –0.55*** –0.56*** 1.54***
(0.15) (0.16) (0.14)
(%dark_pool)2 0.71 0.74 –2.86***
(0.55) (0.56) (0.35)
Observations 19,310 19,328 19,328
Adjusted R2 0.183 0.399 0.169
F-statistic 87.28 257.97 121.66
Notes: This table shows the full sample results of regressing the three market quality variables (quoted bid–offer
spread, relative bid–offer spread, and average top-of-book dollar depth) on the market shares of internalization and
dark pools and their respective squares. The regression also controls for factors known to affect market quality—
specifically, volatility (measured by the log standard deviation of daily returns), market capitalization, and price.
Heteroscedasticity and autocorrelation robust standard errors are shown in parentheses.
*Significant at the 10% level.
 **Significant at the 5% level.
***Significant at the 1% level.

42 www.cfapubs.org ©2014 CFA Institute

 Dark Trading and Equity Market Quality

as the proportion of dark trading increases. The
diminishing benefit may ultimately reverse, such
that dark trading may have a negative impact on
market quality. However, given the relative lack of
observations of stocks with dark trading in excess
of 60% (as noted previously), it is difficult to make
conclusive inferences about market quality when
dark trading dominates. We suggest a possible eco-
nomic interpretation of these coefficients in the sec-
tion “Threshold Effect” and Figures 5 and 6.
To examine the consistency of these find-
ings, we estimated the same regressions for each
market-capitalization subsample. For each sub-
sample, the results (shown in Table 4, Table 5, and
Table 6) are qualitatively similar: Market quality
initially improves, but the improvement dimin-
ishes as dark trading increases. For large caps and
medium caps, dark pool activity has a relatively
stronger effect on market quality than internaliza-
tion has, whereas for small caps, internalization
has a relatively stronger effect. This result may not
be surprising; as noted previously, dark pools are
relatively more active for large- and medium-cap
stocks, whereas internalization is relatively more
intensive among small-cap stocks.
For each subsample regression, the control
variables exhibit the same expected relation with
respect to the dependent variables and are mostly
statistically significant. The coefficients on the dark
trading variables are also mostly statistically sig-
nificant and exhibit the same nonlinear effects as
documented for the total sample. Dark pool activ-
ity (for both the linear and squared terms) is highly
significant for quoted spreads, relative spreads, and
dollar depth in the large- and medium-cap regres-
sions. Internalization (both the linear and squared
terms) is statistically significant for relative spreads
in all the market-capitalization subsamples, with
the strongest effect in the small-cap regression.
To test the robustness of our findings, we ran
a second set of regressions using the general-
ized method of moments (GMM) approach and
incorporating lagged values of the dependent
and independent variables as instruments. This
approach is designed to ameliorate any endoge-
neity issues. The results of the GMM regressions
are qualitatively similar to our previous find-
ings, although the statistical significance is less
uniform (significance is strongest for dark pool
activity on quoted and relative spreads but is less

Table 4.  Large-Cap Subsample Regression Results

ln(Quoted Spread) ln(Relative Spread) ln(Dollar Depth)
Constant 0.85 9.99*** –1.19
(1.77) (1.76) (2.64)
ln(σ) 0.17*** 0.18*** –0.37***
(0.02) (0.02) (0.04)
ln(mkt_cap) –0.29*** –0.29*** 0.57***
(0.09) (0.09) (0.13)
ln(price) 0.70*** –0.29*** –0.76***
(0.10) (0.10) (0.16)
%internal –1.51*** –1.47** 3.06***
(0.57) (0.57) (0.76)
(%internal)2 5.91* 5.82* –3.00
(3.22) (3.21) (3.78)
%dark_pool –0.84*** –0.87*** 3.06***
(0.23) (0.23) (0.48)
(%dark_pool)2 2.18*** 2.25*** –7.12***
(0.82) (0.83) (1.92)
Observations 6,829 6,830 6,830
Adjusted R2 0.216 0.533 0.254
F-statistic 18.09 153.41 53.5
Note: See notes to Table 3.
*Significant at the 10% level.
 **Significant at the 5% level.
***Significant at the 1% level.

November/December 2014 www.cfapubs.org 43

Financial Analysts Journal

Table 5.  Medium-Cap Subsample Regression Results

ln(Quoted Spread) ln(Relative Spread) ln(Dollar Depth)
Constant 3.41* 13.00*** –3.63
(1.80) (1.80) (2.87)
ln(σ) 0.19*** 0.19*** –0.21***
(0.02) (0.02) (0.03)
ln(mkt_cap) –0.42*** –0.43*** 0.65***
(0.10) (0.10) (0.16)
ln(price) 0.80*** –0.19 –0.36*
(0.12) (0.12) (0.18)
%internal –0.52* –0.72** 1.22***
(0.28) (0.29) (0.44)
(%internal)2 1.41 1.90* –1.30
(1.05) (1.08) (1.43)
%dark_pool –0.92*** –0.90*** 1.69***
(0.13) (0.14) (0.25)
(%dark_pool)2 2.03*** 2.00*** –3.46***
(0.37) (0.38) (0.68)
Observations 6,899 6,904 6,904
Adjusted R2 0.236 0.571 0.231
F-statistic 27.02 155.67 48.48
Note: See notes to Table 3.
*Significant at the 10% level.
 **Significant at the 5% level.
***Significant at the 1% level.

consistent among other variables). This result is
perhaps not surprising given the smaller num-
ber of observations used for GMM estimation.
Overall, the GMM regressions lend validity to our
model specification.
Threshold Effect. As noted previously, the
coefficients for %internal and %dark_pool and their
squares imply the possibility of a turning point
in the relation between dark trading and market
quality. That is, market quality initially improves
as dark trading increases but plateaus or declines
beyond a certain threshold.
This effect is illustrated in Figure 5. The figure
plots the relative bid–offer spread (in basis points)
predicted by the regression equation for different
proportions of internalization. The relation between
internalization and the relative spread is the focus
for two reasons. First, the regressions with relative
spread as the dependent variable exhibit the strong-​
est explanatory power. Second, the effect of inter-
nalization on the relative spread, in both linear and
squared terms, is statistically significant throughout
all the samples, so it exhibits the most consistency.
Figure 5 is based on the regression output for the
total sample in Table 3 and was created by calculating
fitted values for the spread for different proportions
of internalization activity while holding all other
variables constant at their sample means. Therefore,
the figure effectively shows a two-dimensional slice
through the regression along the internalization
dimension and thus provides a visual representa-
tion of the relation. As noted previously, owing to
the relative lack of data at high proportions of dark
trading, the focus of this exercise was to identify the
location of the minimum point, rather than the steep
right tail. Figure 5 enables one to identify the prox-
imity of the point at which the benefits of dark trad-
ing are exhausted for the average stock.
The estimated minimum point for the rela-
tion between internalization and relative bid–offer
spreads predicted by the model is 43%, as shown in
Figure 5. That is, beyond a market share of approxi-
mately 43%, internalization does not appear to
improve market quality and may actually cause dete-
rioration. The minimum point lies within our data
range, lending validity to the quadratic specification.

44 www.cfapubs.org ©2014 CFA Institute

 Dark Trading and Equity Market Quality

Table 6.  Small-Cap Subsample Regression Results

ln(Quoted Spread) ln(Relative Spread) ln(Dollar Depth)
Constant 1.63 10.90*** 2.89**
(1.14) (1.18) (1.34)
ln(σ) 0.31*** 0.32*** –0.15***
(0.03) (0.03) (0.02)
ln(mkt_cap) –0.25*** –0.25*** 0.23***
(0.07) (0.07) (0.08)
ln(price) 0.79*** –0.19*** 0.39***
(0.05) (0.06) (0.09)
%internal –0.60*** –0.64*** 0.21
(0.12) (0.12) (0.13)
(%internal)2 0.68*** 0.72*** –0.08
(0.15) (0.14) (0.16)
%dark_pool –0.42** –0.46** 0.44**
(0.20) (0.20) (0.19)
(%dark_pool)2 0.30 0.36 –1.04***
(0.57) (0.58) (0.30)
Observations 5,582 5,594 5,594
Adjusted R2 0.173 0.25 0.155
F-statistic 64.4 53.8 57.52
Note: See notes to Table 3.
*Significant at the 10% level.
 **Significant at the 5% level.
***Significant at the 1% level.

Figure 5.  Predicted Bid–Offer Spread and Internalization

Spread (bps)
18.0
17.5
17.0
16.5
16.0
15.5
15.0
14.5
14.0
13.5
13.0
12.5
12.0
11.5
11.0
10.5
10.0
0 10 20 30 40 50 60 70 80 90 100
Proportion of Internalization (%)

Note: This figure plots the fitted values for the relative bid–offer spread (in basis points) for differ-
ent proportions of internalization using the estimated regression model from Table 3.

November/December 2014 www.cfapubs.org 45

Financial Analysts Journal

To check the robustness of these findings, we fol-
lowed the same procedure for different subsamples.
An array of possible values for the minimum point
in the relation between dark trading activity (both
internalization and dark pools) and relative spreads is
shown in Table 7. These values were estimated using
the regression output shown in Tables 3–6. Note that
these values are point estimates predicted by the
model as dark trading activity increases, assuming all
other variables stay constant at their sample means.
These points should not, therefore, be considered
definitive numbers; rather, they are indications of
the approximate levels at which increases in the mar-
ket share of dark trading cease to be associated with
improvements in market quality. As Table 7 shows, the
level of the threshold varies according to the type of
dark trading and market capitalization segment. For
example, large- and medium-cap stocks have notably
lower thresholds, ranging from 12.6% to 22.5%.
From a policy perspective, the relation between
aggregate undisplayed trading and market quality is
also of interest. Accordingly, we estimated a separate
regression (see Table 8) that is analogous to Equation
1 but that substitutes %internal, %dark_pool, and
their respective squares with a single undisplayed
trading variable—%undisplayed—and its square,
capturing aggregate dark trading. Varying the pro-
portion of aggregate undisplayed trading while
holding the other parameters constant at their sam-
ple means yields the relation between relative bid–
offer spreads and dark trading shown in Figure 6.
The figure shows that the estimated minimum point

Table 7.  Market Quality Threshold Points

Full Sample Large Cap Medium Cap Small Cap
Internalization 43.2% 12.6% 18.9% 44.4%
Dark pool 37.8 19.3 22.5 63.9
Notes: This table presents the internalization and dark pool trading market shares (for the full
sample and the large-, medium-, and small-cap subsamples) beyond which market quality
ceases to improve. These market shares were estimated by calculating the turning point of the
parabola implied by the relevant parameter estimates for the linear and squared internalization
and dark pool regressors in Tables 3–6. Figures in bold indicate calculations based on statisti-
cally significant coefficients.

Table 8.  Full Sample Regression Results: Aggregate Undisplayed Trading

ln(Quoted Spread) ln(Relative Spread) ln(Dollar Depth)
Constant 1.83* 11.20*** 0.66
(0.94) (0.97) (2.17)
ln(σ) 0.23*** 0.23*** –0.21***
(0.01) (0.01) (0.02)
ln(mkt_cap) –0.32*** –0.33*** 0.41***
(0.05) (0.05) (0.12)
ln(price) 0.78*** –0.21*** –0.07
(0.05) (0.05) (0.14)
%undisplayed –0.68*** –0.70*** 0.81***
(0.08) (0.08) (0.11)
(%undisplayed)2 0.72*** 0.75*** –0.70***
(0.11) (0.11) (0.15)
Observations 19,310 19,328 19,328
Adjusted R2 0.187 0.401 0.168
F-statistic 116.66 389.15 162.24
Notes: This table shows the full sample results of regressing the three market quality variables (quoted
bid–offer spread, relative bid–offer spread, and average top-of-book dollar depth) on the aggregate market
share of undisplayed trading and its square. The regression also controls for factors known to affect market
quality—specifically, volatility (measured by the log standard deviation of daily returns), market capital-
ization, and price. Heteroscedasticity and autocorrelation robust standard errors are shown in parentheses.
*Significant at the 10% level.
 **Significant at the 5% level.
***Significant at the 1% level.

46 www.cfapubs.org ©2014 CFA Institute

 Dark Trading and Equity Market Quality

Figure 6.  Predicted Bid–Offer Spread and Undisplayed Trading

Spread (bps)
18.0
17.5
17.0
16.5
16.0
15.5
15.0
14.5
14.0
13.5
13.0
12.5
12.0
11.5
11.0
10.5
10.0
0 10 20 30 40 50 60 70 80 90 100
Proportion of Undisplayed Volume (%)

Notes: This figure plots the fitted values for the relative bid–offer spread (in basis points) for differ-
ent proportions of aggregate undisplayed trading. The estimated regression model used is shown
in Table 8.

in the relation between aggregate undisplayed trad- Conclusion

ing and relative bid–offer spreads is 46%.
A conservative summary of these results is that
when the majority of trading in a stock occurs in undis-
played venues, market quality benefits are exhausted
and any further increase in dark trading may lead to
a deterioration in market quality. As Table 7 shows,
the actual threshold could be significantly lower than
50% and is a function of the type of dark trading and
the market capitalization of the stock.
One possible explanation is that initially, competi-
tion for order flow among on- and off-exchange ven-
ues causes more aggressive quoting in the limit order
book. While lit markets dominate, this competition
helps reduce bid–offer spreads. But when dark mar-
kets dominate, investors may become disincentivized
to display orders and may withdraw quotes because
of the reduced likelihood of those orders being filled
on acceptable terms. That is, the reward from display-
ing orders is not commensurate with the risk when
dark venues dominate, owing to adverse selection
effects (the lit market becomes increasingly “toxic” as
more uninformed order flow is preferenced in dark
venues). Consequently, limit order submission may
decline, which would lead to wider displayed spreads
and lower depth at best prices. In short, competition
between lit and dark markets is initially beneficial
for market quality, but when dark venues dominate,
adverse selection risk negates these benefits.
US equity market structure has evolved dra-
matically over the last decade, with increasing
technological sophistication and fragmentation.
Competition for order flow between displayed and
dark trading venues has lowered indirect trading
costs in the form of bid–offer spreads. Within this
fragmented market structure, dark trading—in the
form of broker/dealer internalization and dark
pools—has grown significantly. Dark pools have
helped reduce information leakage, minimize
market impact, and increase investor choice. The
development of algorithmic trading and smart
order routing has allowed investors to further
optimize their order execution capabilities.
The results of our analysis suggest that dark
trading does not harm market quality at low levels.
Increases in internalization and dark pool activity
were found to initially be associated with lower
bid–offer spreads and higher depth. However, the
marginal benefit from dark trading declines as
dark trading increases, such that beyond a certain
threshold, increases in dark trading may be asso-
ciated with declining market quality. The level of
this threshold appears to depend on the type of
dark trading and the market capitalization of the
stock. Our results conservatively suggest that if
the majority of trading in a given stock takes place
in dark venues, adverse selection risk will negate

November/December 2014 www.cfapubs.org 47

Financial Analysts Journal
or even dominate the benefits of competition.
Investors may become disincentivized from quot-
ing aggressively in the limit order book, which
could lead to a widening of bid–offer spreads and
a reduction in depth as dark trading increases.
These findings have relevance for public policy.
Given the current level of dark trading in the stock
market, regulators should monitor its growth and
consider introducing measures that limit the use of
dark orders and dark trading facilities if such activ-
ity becomes excessive.
Notes
1. In the quarter following the “flash crash” of 6 May 2010,
volumes migrated back to exchanges. This migration likely
reflects a reduction in investor confidence following the
event and a perceived lower counterparty risk from trading
on exchanges compared with off-exchange venues.
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We would like to extend particular thanks to Jeffrey
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©2014 CFA Institute