Dark trading improves market quality up to a point, but beyond that point, it can have negative effects, suggests a new study.

The study, published Monday by the CFA Institute, finds that increases in dark trading are initially associated with improvements to market quality, such as declining bid-offer spreads and increasing market depth. However, beyond a certain threshold, the proportion of dark trading harms market quality. Indeed, the study estimates that when over 50% of trading in a stock occurs in undisplayed venues, market quality starts to deteriorate.

“If the majority of order flow is filled away from pre-trade transparent markets, investors could withdraw quotes because of the reduced likelihood of those orders being filled. As investors become disincentivized from displaying orders, bid–offer spreads are likely to widen,” it says. “Therefore, competition should be maintained to encourage aggressive quoting in displayed order books and a predominance of dark trading should be avoided.”

Indeed, the study concludes that maintaining strong competition between trading on lit and dark venues is the best prescription for preserving market quality. To that end, the study recommends that policy measures should support fair competition, and protect investors who display quotes in the public markets.

Specifically, the CFA Insitute recommends that, among other things, regulators should monitor the growth in dark trading, and intervene if it gets too big; that internalized retail orders should be required to provide meaningful price improvement; and, that dark trading facilities should voluntarily improve reporting and disclosures around their operations, to enable investors and regulators to make more informed decisions over their use.

“We believe that implementation of these considerations would help protect displayed orders while offering meaningful savings to retail investors executing away from public markets, maintain competition, and improve transparency. More fundamentally, these measures would enhance market integrity and lead to greater investor confidence in the equity market structure,” said Rhodri Preece, director of Capital Markets Policy, CFA Institute.