Ethical Issues with Dark Liquidity and the Ethics of Possible Remedies

October 30, 2014

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.

Download complete article as PDF

Back to Journal Contents

About the Journal

Moral Cents: The Journal of Ethics in Finance (Summer/Fall 2014)

Financial regulations have proliferated since the Global Financial Crisis. Some, having lost their faith in self-regulation, welcome the new rules. Others, clinging to the belief that a free market ensures financial actors will self-regulate, deplore the promulgation of clumsy and poorly designed regulations. Both sides are right. Regulations are necessary in an ethically unconstrained world but they are sometimes badly thought out, arise too hastily, and have negative unintended consequences. Less regulation is of course more desirable. Yet, for self-regulation to function properly, individual actors must possess a sense of values and work in a culture that genuinely promotes, rather than pays lip service to, ethical behavior.
Thus, the promotion of ethics in individuals and organizations decreases the need for regulations.
This issue of Moral Cents focuses on financial regulations over a diverse range of transactions and actors around the world.
Daryl Koehn and Jo Lynne Koehn analyze dark liquidity or dark pools and the ethical issues associated with them. They bring to light some less obvious but yet, significant problems connected to dark liquidity. The authors direct attention to three possible ways for coping with the problems and ultimately choose a policy of targeted regulations to benefit investors.
Steven Wu writes about corporate governance in Hong Kong, within the context of the Hong Kong Securities and Futures Commission’s new rules for the sponsor regime governing initial public offerings. Mr. Wu questions the rigidity of these new rules. While the reforms are ethically upstanding, their long-term consequences remain to be seen.
Rebecca Wong investigates UK’s Regulators’ Code and analyzes the effectiveness of financial regulation. The Code was published by the Better Regulation Delivery Office in April 2014 and is meant to reduce regulatory burdens. Ms. Wong critiques the Code, finding it lacking, and recommends instead that regulators stress the great need to engender a culture of ethics within the financial services industry.
Calvin Benedict gives an opinion piece calling for enlightened leadership in finance. He uses examples from the Barclays bonuses and job cuts case as well as the BNP Paribas sanctions case. Benedict recommends leaders play a decisive role in building a sense of the systemic and promoting the common good.
Maja Cvjetanovic provides insight into the concept of consumer sovereignty and applies it to recent payday lending reforms in Australia. She argues that consumer sovereignty should be preserved as a ‘normative standard’ and not used in its descriptive sense, as championed by neoliberalism to mean the consumer’s rational ability to fulfill wealth- maximizing preferences. In any case, empirical evidence refutes the latter point of view.
Vesko Karadotchev continues in the vein of criticizing the neoliberal economic model. In particular, he critiques the two major versions of the Homo economicus model, which has dominated economics for a century, and argues both versions have major flaws. The first version is not supported empirically, while the second is too general to be useful. Neither can hope to fully describe human economic behavior.
It would be a fine thing indeed to have as little regulation as possible. But this ideal is a distant goal if we continue to adhere to flawed and empirically disproved economic models. Bring back values into economics and finance, use an economic theory in which ethics plays a central role, then, chances are, regulations cease proliferating.

Editorial by Dr. Kara Tan Bhala

Moral Cents: The Journal of Ethics in Finance is published by
Seven Pillars Institute for Global Finance and Ethics
ISSN 2326-5663

View all Journals

Download complete article as PDF

Contact