Dark pools are private exchanges for trading securities that are not accessible by 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.
- Dark pools are private exchanges for trading securities that are not accessible by the investing public.
- Dark pools were created in order 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.
- According to the most recent SEC data, there were 59 registered Alternative Trading Systems (a.k.a.: "Dark Pools") with the SEC as of May 2021.
An Introduction To Dark Pools
The Rationale for Dark Pools
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 an estimated 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 either:
- Work the order through a floor trader over the course of one or two days and hope for a decent VWAP (volume-weighted average price).
- Split the order up into, for example, five pieces and sell 200,000 shares per day.
- 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 XYZ shares 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.
Why Use a Dark Pool?
Contrast this with the present-day situation, where an institutional investor can use a dark pool to sell a one million share block. The lack of transparency actually 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. Note that, as 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.
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.
Types of Dark Pools
As of February 2020, there were more than 50 dark pools registered with the Securities and Exchange Commission (SEC), of which there are three types:
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 Credit Suisse's CrossFinder, Goldman Sachs’ Sigma X, Citibank’s Citi-Match, and Morgan Stanley’s MS Pool.
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 Makers Dark Pools
These are dark pools offered by independent operators like Getco and Knight, who operate as principals for their own accounts. Like the broker-dealer-owned dark pools, their transaction prices are not calculated from the NBBO, so there is price discovery.
Advantages and Disadvantages of Dark Pools
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 stock and sells it off in a dark pool, the sale of the stake may fetch the fund a good price. However, unwary investors who have just bought RST shares will have paid too much since the stock could collapse once the fund’s sale becomes public knowledge.
The lack of transparency in dark pools 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 in cases where 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.
While regulated 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.
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 to the The 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 only about 200 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.
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 pose a threat to their long-term viability.