Dark pools of liquidity are private stock exchanges designed for trading large blocks of securities away from the public eye. These trading venues are called "dark" because of their complete lack of transparency, which benefits the big players but may leave the retail investor at a disadvantage.
Large investors prefer dark pools over public stock exchanges like the New York Stock Exchange or Nasdaq because they can discreetly buy or sell huge numbers of shares—in the hundreds of thousands or even millions—without worrying about moving the market price of the stock simply by expressing intention. But dark pools have grown so much over the years that experts are now worried that the stock market is no longer able to accurately reflect the price of securities. While estimates vary, dark pools are estimated to account for up to 18% of U.S. and 9% of European trading volumes. Here are some of the pros and cons of dark pools.
Advantages of Dark Pools
- Limited market impact: The main reason why dark pools came into existence was because of their promise to significantly reduce the market impact of large orders. Institutional investors and traders have to constantly contend with the fact that the market moves adversely when they buy or sell large blocks of shares. As a result, they end up paying more than they would like for purchase transactions, and receive lower prices than they may have expected for sale transactions. The public markets' feature of complete transparency does not work to the advantage of large investors, since their trading intentions are visible to all. In contrast, because dark pools are not accessible to the public and are completely opaque, large block trades can be crossed without retail investors being any the wiser about the parties involved, the trade size, or the execution price. As a result, trades executed in dark pools will have very limited market impact compared with similar trades executed on public exchanges.
- Potentially better prices: Since dark pools typically only have large players as participants, big orders can be matched by the pool operator at prices that may be more favorable than those on public exchanges. For instance, crossing orders at the midpoint of the best bid and ask prices would result in a better price obtained by both the buyer and the seller.
- Lower costs: Trades executed on dark pools do not incur exchange fees. This can add up to significant cost savings over time. Orders crossed at the midpoint of the bid-ask spread also reduce costs associated with the spread.
Disadvantages of Dark Pools
- Off-market prices may be far from the public market: The prices at which trades are executed in dark pools may diverge from prices displayed in the public markets, which puts retail investors at a huge disadvantage. For example, if a number of large institutions decide independently to dump their holdings of a stock, and the sale gets executed within a dark pool at a price well below the public exchange price, retail buyers who are unaware of the selling that has taken place privately are at an unfair disadvantage.
- Possible inefficiency and abuse: The lack of transparency in dark pools could result in poor execution of trades or abuses such as front-running (buying or selling for one's own account based on advance knowledge of client orders for a security). Conflicts of interest are also a possibility. For example, the pool operator's proprietary traders could trade against pool clients. The Securities and Exchange Commission has already cited violations and fined some banks that operate dark pools.
- Predatory tactics by high-frequency traders: In his bestseller Flash Boys: A Wall Street Revolt, Michael Lewis points out that the opacity of dark pools makes client orders vulnerable to predatory trading practices by high-frequency trading firms. One such practice is called pinging. A high-frequency trading firm puts out small orders so as to detect large hidden orders in dark pools. Once such an order is detected, the firm will front-run it, making profits at the expense of the pool participant. Here's an example: A high-frequency trading firm places bids and offers in small lots (like 100 shares) for a large number of listed stocks; if an order for stock XYZ gets executed (i.e., someone buys it in the dark pool), this alerts the high-frequency trading firm to the presence of a potentially large institutional order for stock XYZ. The high-frequency trading firm would then scoop up all available shares of XYZ in the market, hoping to sell them back to the institution that is a buyer of these shares.
The Bottom Line
While dark pools offer distinct advantages to large players, the lack of transparency that is their biggest selling point also results in a number of disadvantages. These include price divergence from the public markets and a potential for abuse.