Should You Be Afraid Of Dark Pool Liquidity?

By Brent Radcliffe AAA

The term "dark pools," can make your skin crawl. Are there murky swamps on Wall Street in which bankers lurk in the darkness? Sadly for you sci-fi fans out there, dark pools are nothing of the sort. In fact, while they might be reserved for the institutional investor, dark pools can actually help drive down the cost for the average investor.

What is Liquidity?
Liquidity is the degree to which an asset or security can be bought or sold in the market without affecting the asset's price. Liquidity is characterized by a high level of trading activity. Assets that can be easily bought or sold are known as liquid assets.

What Is Dark Pool Liquidity?
Dark pool liquidity, also referred to as dark pool financing or dark pools, is a little more mysterious because transaction information is concealed from parties not involved in the trade - namely, the general public. The average investor is unlikely to ever know that the trade happened.

Why would someone want to conceal this sort of trade information? Anonymity. If an institutional investor looking to make a large block order – think thousands or millions of shares of a security – makes a trade on the open market, investors across the globe will see a spike in volume. This might prompt a change in the price of the security, which in turn could increase the cost of purchasing the block of shares. When thousands of shares are involved, even a small change in share price can translate into a lot of money. If only the buyer and seller are aware of the transaction, both can skip over market forces and get a price that's better suited.

Institutional investors, broker dealers and investors have turned to dark pools for their trades. These trades occur off of traditional exchanges, which increasingly handle smaller orders for securities that are traded frequently. Instead of selling a block of 100,000 shares on the NYSE, investors could break this into much smaller portions, perhaps as small as a few hundred shares. Through the assistance of computer algorithms, the shares are then sold off to other investors using the dark pools to match orders.

Instead of personally hunting for the best stock price, institutional investors use trading platforms that scour different exchanges, networks and dark pools for the best price. This sort of activity is incredibly intense, which is why it simply could not exist before the advent of fast-thinking computers.

This sort of trade is only hidden during the preliminary stages of the transaction, when the buyer and seller are setting the security's price. Once the order is executed, it becomes available to the public on the consolidated tape, which records all the transactions of exchange-traded securities on all exchanges.

Dark pools carry some similarities with other alternative trading systems (ATSs), such as crossing networks and electronic communications networks (ECN). The primary function of an ATS is to keep trades out of the public view, but they also allow matching to occur at specific prices. (Learn more about ECNs in our Electronic Trading Tutorial.)

What Are the Advantages?
Institutional investors, such as mutual fund companies and pension funds, use dark pools to lower their trading costs, sell securities that tend to be less liquid (low volume) and to make trades anonymously. Trading costs are lower because electronic platforms are able to slice and dice large bulk orders into smaller pieces and execute trades faster and simpler, and because they charge lower per-share fees.

The ability to bundle a variety of investments and sell them as a portfolio off of the open market, especially when such a transaction could be visible to the public before execution, could negatively impact the security's price.

What Are the Disadvantages?
Just as investors use dark pools to conceal pre-trade information from the public, so to can information come back to haunt them. If other investors become aware of the particular securities involved in a dark pool trade before it is executed, they can preemptively buy or sell their shares in order to take advantage of the current price. This is referred to as "gaming."

Another concern is just how buy and sell orders are displayed to potentially interested parties. Software programs attempt to limit pre-trade "noise" by only allowing firms to see buy or sell orders that match what they are looking to buy or sell. This means that, instead of soliciting a trade, the software is providing a sort of meet-and-greet for orders.

Investors who use dark pools and other ATSs still rely, to a certain degree, upon physical exchanges to set security prices at the beginning and end of each day.

What Does Dark Pool Liquidity Do to the Market?
In 2008, dark pools made up roughly 9% of traded volume in equities in the United States and 5% in Europe. Conventional stock exchanges, with brokers barking out buy and sell orders, have been fighting to maintain relevance as electronic trading platforms have increased in popularity. Several physical exchanges have snapped up electronic trading platforms in recent years in order to tap into this growing market.

The rise in popularity of dark pools raises questions for both investors and regulators. With a significant portion of trades occurring without the knowledge of the everyday investor, information asymmetry becomes an issue of greater importance.

What do regulators, such as the Securities and Exchange Commission (SEC), feel about dark pools? One concern with dark pools is that a large volume of off-exchange trading could mean that investors aren't getting the best price available, and impedes the price discovery function of the market. In fact, the larger the portion of trades executed through dark pools, the more investors will question the meaning and reliability of publicly displayed securities quotes. Some regulations have already been enacted, such as requiring ATSs to make information public if more than a certain volume of shares is being bought and sold. The other major concern for regulators is the potential gaming or exploitation of dark pool orders and its impact on investors. (Dark pools are also often used as a venue for high frequency trading (HFT); learn what this is in our FAQ: What is high-frequency trading?)

Conclusion
Dark pool financing, while hidden from the public eye, may provide individual investors with more benefits than costs. Reducing trading costs and increasing efficiencies can make trading securities cheaper across the board, and forces traditional exchanges to innovate in order to remain competitive.

For further reading on a related topic, see The Global Electronic Stock Market.

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