The eclipse of lit markets: understanding the rise of opaque trading mechanisms in Europe – ECLIPSES

This proposal outlines a research agenda for an empirical approach to studying the role of dark or opaque trading mechanisms in Europe.

Trading arrangements that limit pre-trade transparency can be divided into two categories. The first includes off-exchange venues like dark pools. The second is composed of hidden orders, which totally or partially conceal their total size. Both categories have a symbiotic relationship with lit markets: off-exchange trading typically derives a price from a reference lit market as a matching point, while hidden orders operate within lit limit order book markets.

Dark trading is material nowadays. In Europe, like in the US, around 60% of equity volume trades off-exchange, eclipsing lit markets. Dark trading mechanisms respond to investors’ opacity needs, helping them limit their order exposure and reduce transaction costs. Investors are sensitive to high-frequency traders (HFTs), a category of sophisticated participants now dominating electronic markets and lit order books markets. HFTs can detect and prey on trades sent by large investors, who, in turn, prefer trading in the dark.

Diving into the impact of dark mechanisms is crucial to understanding liquidity in Europe especially because European regulators are divided about their impact. The EU is in favor of further curtailing dark trading. In a post-Brexit regime, London has decided to loosen dark trading rules. This proposal aims to contribute to the debate about opaque trading by zooming in on two mechanisms: (i) midpoint trading, which consists of executing orders in the dark at the midpoint price defined by the reference lit market; (ii) hidden orders. The first project will analyze the impact of midpoint execution on market quality using state-of-the-art causal inference techniques. The second project will focus on the value of hidden orders by developing a structural model of a limit order book, which will also allow to run counterfactual analyses.