Welfare Analysis of Dark Pools∗

We investigate the welfare implications of operating alternative market structures known as electronic crossing networks or “dark pools” alongside traditional “lit” markets. We study equilibria of a market where intrinsic traders and speculators, endowed with heterogeneous fine-grained information, endogenously choose between dark and lit venues. We establish that while the dark pool attracts relatively uninformed investors, the orders therein experience adverse selection. Moreover, the informational segmentation created by a dark pool leads to greater transaction costs in the lit market. Taken together, we conclude that there exist reasonable parameter regimes where introducing a dark pool decreases the overall welfare. ∗Portions of this work were carried out while the first author was a graduate student at Stanford University. The second author was supported by NSF Grants CMMI-1234955, CMMI-0948434, CNS-0904609, CCF0832820, and CNS-0644114. The third author was supported by NSF Grant CMMI-1235023.