Ethical Issues with Dark Liquidity and the Ethics of Possible Remedies

 

Abstract: Although considerable attention has been devoted by researchers and journalists to high frequency trading, considerably less attention has been paid to another major financial development—traders’ growing use of “dark liquidity” or “dark pools.” This paper discusses 1) the nature of dark liquidity; 2) the reasons behind the increasing use of dark pools; 3) the wide array of ethical issues—some obvious, some less so—connected with dark liquidity; and 4) the ethical merits of various options for coping with the problems associated with dark liquidity.

 

Financial markets are evolving quickly. This evolution raises a number of ethical issues. Most of the ethical attention during the past five years has centered on the rise of high frequency trading – i.e., computer trading at astronomically fast speeds that may favor big players over smaller players who do not use algorithms and fast computers to execute trades. Far less attention has been paid to another major financial development—traders’ growing use of “dark liquidity” or “dark pools.” This paper discusses 1) the nature of dark liquidity; 2) the reasons behind the increasing use of dark pools; 3) the wide array of ethical issues connected with dark liquidity; and 4) the ethical merits of various options for coping with the problems associated with dark liquidity.

We bring together into one place various ethical issues that currently have been touched upon piecemeal in the financial literature and popular press, while identifying some issues no one has yet discussed. In addition, we explore the ethical concerns in greater detail than has been done to date and evaluate the ethical merits of proposed ways of dealing with the rise of dark liquidity. Although academics in finance have written articles on matters such as how trading volume in dark pools varies from day to day (Buti et al, 2011); on the various incentives to trade in dark pools (Degryse, 2008); on the behavior of informed versus uninformed traders when it comes to using dark pools (Zhu, forthcoming); and on increasing market fragmentation (Blume, 2007), we could find few detailed or systematic discussions of dark pool ethical issues. Nor could we find any ethical evaluation of various options for dealing with the explosion of dark pools.

 

Jo Lynne Koehn, Ph.D., is a professor of accountancy at the University of Central Missouri in Warrensburg, Mo. She holds the BKD Distinguished Accounting Professorship and teaches a variety of financial accounting courses, including financial statement analysis. Daryl Koehn, PhD, is a professor of business ethics at the University of St. Thomas in the Twin Cities, Minnesota. She is the author of numerous books and articles on business ethics.