Impact of Growing Importance of Dark Pool to Market Efficiency

Investopedia explains Dark Pool LiquidityThe dark pool gets its name because details of these trades are concealed from the public, clouding the transactions like murky water. Some traders that use a strategy based on liquidity feel that dark pool liquidity should be publicized, in order to make trading more "fair" for all parties involved.

We read this new in 04 January 2011

Another factor jumped into the fray in December: dark pools. Off-exchange trading accounted for more than a third of the trading volume in December, says Raymond James. While these trades are eventually reported to the public markets, they further damage price discovery, an essential element for a fair securities market, investors said.

http://www.cnbc.com/id/40907838/

this news got a serious implication to market efficiency, reasons:

first, from market participant perspective, dark pool was created to accommodate trading and liquidity needs of institutional investor. Since, institutional investor got capabilities and resources to analyze stock, their transaction match the assumption of efficient market hypothesis. Stock price always right. Another implication will be regular stock market mostly accomodate trading and liquidity needs of retail investor, which we quite doubting their capabilities and resources to analyze stock, their transaction do not match the assumption of efficient market hypothesis.

second, from efficient market hypothesis assumption perspective, since transaction in dark pool being performed by investor who have adequate information and capabilities to analyze, transaction by this kind of investor match the assumption of efficient market hypothesis, hence we would expect stock price change in dark pool market tend to be random. Transaction in regular market usually performed by retail investor, who do not have enough information and enough capabilities to analyze stock, hence we would expect their ransaction do not match the assumption of efficient market hypothesis, we would expect market sometimes have random behavior and some other times have a price drift behavior or stock price change have some predictability feature. Or, we have two kind of market efficiency in one stock market.

third, from reflexivity perspective, a term we borrow from legendary hedgefund manager, George Soros, we do see that dark pool and regular stock market influence each other, and we suspect there are (1) a lot of cases stock price divergence between dark pool market and regular stock market and (2) price divergence will convergence again and the process may be an abrupt change.