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An Introduction to Dark Pools

An Introduction To Dark Pools

Dark pools are private exchanges for trading large chunks of securities that are not accessible to the public.They facilitate block trading for institutional investors seeking to avoid impacting the market with their large orders. While criticized for their lack of transparency, dark pools can serve a purpose.If dark pools are not available, and a large institutional investor wants to sell 1 million shares of XYZ stock, the impact will be big—investors may see it as a sign to sell XYZ, and the price could fall.A dark pool lets the investor sell the block. The lack of transparency works in her favor as the price will be better than if the shares are sold on an exchange. The investor also has a much better chance of selling them in a block.Broker-dealers, agency brokers and exchanges own dark pools, whose advantages include reduced market impact and lower transaction costs.But dark pools may not reflect real market prices. If a mutual fund owns 20 percent of company RST’s stock and sells it in a dark pool, unaware investors who later buy RST will pay too much for it. RST could then collapse when the fund’s big sale goes public.

Reviewed by Charles PottersFact checked by Melody KazelReviewed by Charles PottersFact checked by Melody Kazel

Dark pools are private exchanges for trading securities that are not accessible to the investing public. Also known as dark pools of liquidity, the name of these exchanges is a reference to their complete lack of transparency.

Dark pools came about primarily to facilitate block trading by institutional investors who did not wish to impact the markets with their large orders and obtain adverse prices for their trades.

Dark pools are sometimes cast in an unfavorable light but they serve a purpose by allowing large trades to proceed without affecting the wider market. However, their lack of transparency makes them vulnerable to potential conflicts of interest by their owners and predatory trading practices by some high-frequency traders.

Key Takeaways

  • Dark pools are private exchanges for trading securities that are not accessible to the investing public.
  • Dark pools were created to facilitate block trading by institutional investors who did not wish to impact the markets with their large orders and obtain adverse prices for their trades.
  • They may be looked at unfavorably but are legal and regulated by the SEC.
  • Trades that take place in dark pools don’t affect the wider market.
  • There are three types of dark pools: broker-dealer-owned dark pools, agency broker or exchange-owned dark pools, and electronic market markers dark pools.

Why Do Dark Pools Exist?

Dark pools emerged in the late 1980s. According to the CFA Institute, non-exchange trading has recently become more popular in the U.S. Estimates show that it accounted for approximately 40% of all U.S. stock trades in 2017 compared with roughly 16% in 2010. The CFA also estimates that dark pools are responsible for 15% of U.S. volume as of 2014.

Why did dark pools come into existence? Consider the options available to a large institutional investor who wanted to sell one million shares of XYZ stock before the advent of non-exchange trading. This investor could do one of the following:

  1. Work the order through a floor trader over the course of one or two days and hope for a decent volume-weighted average price (VWAP).
  2. Split the order up into, for example, five pieces and sell 200,000 shares per day.
  3. Sell small amounts until a large buyer could be found who was willing to take up the full amount of the remaining shares.

The market impact of a sale of one million shares in Company XYZ could still be sizable regardless of which option the investor chose since it was not possible to keep the identity or intention of the investor secret in a stock exchange transaction. With options two and three, the risk of a decline in the period while the investor was waiting to sell the remaining shares was also significant. Dark pools were one solution to these issues.

Note

In contrast to dark pools, traditional exchanges are sometimes described as lit markets.

Why Do Investors Trade on Dark Pools?

Contrast this with the present-day situation, where an institutional investor can use a dark pool to sell a block of one million shares. The lack of transparency works in the institutional investor’s favor since it may result in a better-realized price than if the sale was executed on an exchange.

The institutional seller has a better chance of finding a buyer for the full share block in a dark pool since it is a forum dedicated to large investors. The possibility of price improvement also exists if the mid-point of the quoted bid and ask price is used for the transaction.

Of course, this assumes that there is no information leakage of the investor’s proposed sale and that the dark pool is not vulnerable to high-frequency trading (HFT) predators who could engage in front-running once they sense the investor’s trading intentions.

Important

Since dark pool participants do not disclose their trading intention to the exchange before execution, there is no order book visible to the public. Trade execution details are only released to the consolidated tape after a delay.

Types of Dark Pools

As of the end of December 2022, there were more than 60 dark pools registered with the Securities and Exchange Commission (SEC). There are three types, including broker-dealer-owned dark pools, agency broker or exchange-owned dark pools, and electronic market markers dark pools. We highlight some of the key characteristics of each below.

Broker-Dealer-Owned Dark Pool

These dark pools are set up by large broker-dealers for their clients and may also include their own proprietary traders. These dark pools derive their own prices from order flow, so there is an element of price discovery.

Examples of such dark pools include those from Credit Suisse CrossFinder, Sigma X (from Goldman Sachs), Citi-Match (from Citibank), and MS Pool (from Morgan Stanley).

Agency Broker or Exchange-Owned Dark Pool

These are dark pools that act as agents, not as principals. As prices are derived from exchanges–such as the midpoint of the National Best Bid and Offer (NBBO), there is no price discovery.

Examples of agency broker dark pools include Instinet, Liquidnet, and ITG Posit, while exchange-owned dark pools include those offered by BATS Trading and NYSE Euronext.

Electronic Market Maker Dark Pools

Electronic market maker dark pools are offered by independent operators like Getco and Knight, who operate as principals for their own accounts. Like the dark pools owned by broker-dealers, their transaction prices are not calculated from the NBBO, so there is price discovery.

40%

The percent of U.S. trading volume that occurs in dark pools.

Advantages and Disadvantages of Dark Pools

Pros

  • Are legal and regulated by the SEC

  • Large orders don’t impact market

  • Lower transaction costs

  • Sales on the dark pool may fetch a good price

Cons

  • Not available to retail investors

  • Lack of transparency

  • No best price guarantees

  • Operators accused of misusing dark pool data to trade against customers

  • Dark pool trade sizes have reduced

Advantages

The biggest advantage of dark pools is that market impact is significantly reduced for large orders. Dark pools may also lower transaction costs because dark pool trades do not have to pay exchange fees, while transactions based on the bid-ask midpoint do not incur the full spread.

If the amount of trading in dark pools owned by broker-dealers and electronic market makers continues to grow, stock prices on exchanges may not reflect the actual market. For example, if a well-regarded mutual fund owns 20% of Company RST’s stock and sells it off in a dark pool, the sale of the stake may fetch the fund a good price. Unwary investors who just bought RST shares will have paid too much since the stock could collapse once the fund’s sale becomes public knowledge.

Disadvantages

While dark pools are legal and regulated by the SEC, they have been subject to criticism due to their opaque nature. Because dark pool trades are not available to the public, they have sometimes been used for predatory practices by high-frequency trading firms, using tactics such as pinging dark pools to unearth large hidden orders and then engaging in front-running or latency arbitrage.

The lack of transparency can also work against a pool participant since there is no guarantee that the institution’s trade was executed at the best price. A surprisingly large proportion of broker-dealer dark pool trades are executed within the pools–a process that is known as internalization, even when the broker-dealer has a small share of the U.S. market. The dark pool’s opaqueness can also give rise to conflicts of interest if a broker-dealer’s proprietary traders trade against pool clients or if the broker-dealer sells special access to the dark pool to HFT firms.

Dark pool operators have also been accused of misusing their dark pool data to trade against their other customers or misrepresenting the pools to their clients. According toThe Wall Street Journal, securities regulators have collected more than $340 million from dark pool operators since 2011 to settle various legal allegations.

The average trade size in dark pools has declined to less than 150 shares. Exchanges like the New York Stock Exchange (NYSE), which are seeking to stem their loss of trading market share to dark pools and alternative trading systems, claim that this small trade size makes the case for dark pools less compelling.

Regulating Dark Pools

The recent HFT controversy has drawn significant regulatory attention to dark pools. Regulators have generally viewed dark pools with suspicion because of their lack of transparency. This controversy may lead to renewed efforts to curb their appeal. One measure that may help exchanges reclaim market share from dark pools and other off-exchange venues could be a pilot proposal from the Securities and Exchange Commission (SEC) to introduce a trade-at rule.

The rule would require brokerages to send client trades to exchanges rather than dark pools unless they can execute the trades at a meaningfully better price than that available in the public market. If implemented, this rule could present a serious challenge to the long-term viability of dark pools.

10,000

The minimum number of shares traded in a block trade.

Examples of Dark Pools

When retail investors buy and sell stocks and other securities, they usually go through a brokerage firm or their preferred online trading platform. They decide how many shares they want and choose their order type. Once that’s done, they place the order. These investors normally buy and sell a small number of shares.

Dark pools work differently, though, so let’s take a hypothetical look at how this type of trading works. Say ABC Investment Firm sees a good opportunity in Company 123 and decides to buy 20,000 shares in the company. Since they can’t purchase these shares on the open market, the firm has to go onto a dark pool to make the purchase.

Buying these shares on the dark pool means that ABC Investment Firm’s trade won’t affect the value of the stock. It also won’t alert anyone else about the trade, which means that speculators won’t jump on board and follow suit, thereby driving the price up even higher. As such, no one will know about the transaction until it’s complete.

How Do Dark Pools Affect Stock Prices?

Dark pools are intended to reduce volatility by obscuring large trades. On the open market, large block sales tend to decrease the stock price, by increasing the supply of the security available to trade. Dark pools allow large institutional holders to buy or sell in large volumes, without broadcasting information that could affect the wider market.

Are Dark Pools Legal?

Despite the ominous name, dark pools are not inherently illegal. However, there have been instances of dark pool operators abusing their position to make unethical or illegal trades. In 2016, Credit Suisse was fined more than $84 million for using its dark pool to trade against its clients. Another operator, Barclay’s Capital, paid $70 million. Some have argued that dark pools have a built-in conflict of interest and should be more closely regulated.

What Are Dark Pools in Cryptocurrency?

Cryptocurrency dark pools are similar to the pools in the stock market: they match buyers and sellers for large orders, without a public order book. However, cryptocurrency dark pools may be decentralized through the use of smart contracts. Instead of trading through a trusted intermediary, the buyers and sellers interact through a blockchain-based program that executes the trade without disclosing any confidential information about the transaction or its participants.

Can You Trade on Dark Pools?

Dark pools are privately organized exchanges that are used to trade financial securities. Unlike traditional exchanges, dark pools aren’t available to everyday retail investors. Instead, they’re meant for institutional investors who regularly place large orders for their clients. The purpose is to avoid affecting the market when these large block orders are placed. This allows them to make trades without having to explain their rationale as they look for buyers or sellers.

How Do Dark Pools Differ From Lit Pools?

A dark pool is a private trading system meant for institutional traders. Although it sounds shady, it isn’t. in fact, dark pools are legal and fully regulated by the Securities and Exchange Commission. Dark pools allow traders to make block trades without having to publicize the buy/sell price or the number of shares traded to the public. This means trades are done anonymously and don’t give clues to other traders.

Lit pools are the opposite of dark pools. They show bid/ask prices and the total number of shares traded. They represent the ideal stock market because they are truly transparent.

The Bottom Line

Dark pools provide pricing and cost advantages to buy-side institutions such as mutual funds and pension funds, which hold that these benefits ultimately accrue to the retail investors who own these funds. However, dark pools’ lack of transparency makes them susceptible to conflicts of interest by their owners and predatory trading practices by HFT firms. HFT controversy has drawn increasing regulatory attention to dark pools, and implementation of the proposed “trade-at” rule could threaten their long-term viability.

Read the original article on Investopedia.

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