A dark pool is a privately organized financial forum or exchange for trading securities. Dark pools allow institutional investors to trade without exposure until after the trade has been executed and reported. These platforms give certain investors the chance to place large orders and make trades without publicly revealing their intentions during the search for a buyer or seller.
Key Takeaways
- Dark pools are private asset exchanges designed to provide additional liquidity and anonymity for trading large blocks of securities away from the public eye.
- They offer pricing and cost advantages to buy-side institutions such as mutual funds and pension funds, which ultimately benefit the retail investors in these funds.
- The lack of transparency in dark pools makes them susceptible to conflicts of interest by their owners and predatory trading practices by high-frequency trading (HFT) firms.
The Origins and Growth of Dark Pools
Dark pools emerged in the 1980s when the Securities and Exchange Commission (SEC) allowed brokers to transact large blocks of shares. The rise of electronic trading and a pivotal SEC ruling in 2005 aimed at increasing competition and reducing transaction costs spurred the growth of dark pools. They often charge lower fees than traditional exchanges as they are frequently housed within large firms rather than banks.
Example: The Evolution of Trade Sizes
Dark pools were initially utilized by institutional investors for large block trades of securities. For instance, Bloomberg LP owns Bloomberg Tradebook, a dark pool registered with the SEC. However, trades in dark pools aren’t limited to large orders anymore. A 2013 report indicated that the average order size in dark pools fell from 430 shares in 2009 to around 200 shares, reflecting a broader adoption of dark pool trading.
Advantages of Dark Pool Trading
The primary benefit of dark pool trading is that institutional investors making substantial trades can do so without exposure while seeking buyers and sellers. This shields the transaction from significant price devaluation. For example, if it became public knowledge that an investment bank intended to sell 500,000 shares of security, the value of that security would likely decrease before all shares were sold. The confidentiality offered by dark pools helps mitigate this risk, especially as electronic trading platforms quickly respond to market pressures.
Dark Pools and High-Frequency Trading
The advent of supercomputers capable of executing algorithmic-based trades within milliseconds brought high-frequency trading (HFT) to the forefront, dominating daily trading volumes. HFT technology enables institutional traders to execute multimillion-share blocks orders ahead of other investors, capitalizing on fractional price movements. These swift actions can yield significant profits for HFT traders who then promptly sell off their positions. This process, repeating multiple times a day, led to challenges in executing large trades through a single exchange due to increased transparency.
To circumvent these issues and maintain liquidity for vast trades, many investment banks established private exchanges, known as dark pools. For traders wishing to place large orders discreetly, dark pools provide a conducive environment for liquidity. As of Feb. 28, 2022, there were 64 dark pools operating in the United States, mainly run by investment banks.
Critiques of Dark Pools
While legal, anonymous trading in dark pools operates with minimal transparency. Critics argue that high-frequency trading provides an unfair advantage over other investors and that dark pools further obscure market activities, hiding potential conflicts of interest. Following numerous complaints, the SEC conducted research and scrutinized dark pools in 2015 for illegal front-running, where institutional traders capitalize on orders placed by customers. Advocates counter that dark pools offer essential liquidity that helps markets operate more efficiently.
Types of Dark Pools
Various dark pools exist: broker or dealer-owned exchanges like Morgan Stanley’s MS Pool and Goldman Sachs’ Sigma X; independently owned exchanges serving private clients; and private markets operated by public exchanges such as the New York Stock Exchange’s Euronext. While broker-owned dark pools often derive pricing from public exchanges, independently operated ones possess price discovery mechanisms within their markets.
Because of their shadowy name and opacity, dark pools can seem dubious to the public. However, they are tightly regulated by the SEC. Despite stringent regulations, concerns persist over the potential for dark pools to distort public valuations and aid predatory high-frequency trading.
Related Terms: Alternative Trading System, Block Trades, Anonymous Trading, Price Discovery.
References
- Federal Register. “Regulation NMS”.
- Boston University, Review of Banking and Financial Law. “2013-2014 Developments in Banking Law”, Page 71.
- U.S. Securities and Exchange Commission. “Bloomberg Tradebook LLC, Statement of Financial Condition, December 31, 2020”, Page 7.
- Celent. “Dark Pools: In the Eye of the Storm”.
- U.S. Securities and Exchange Commission. “Staff Report on Algorithmic Trading in U.S. Capital Markets”, Page 38.
- U.S. Securities and Exchange Commission. “Alternative Trading Systems with Form ATS on File with the SEC as of February 28, 2022”.
- U.S. Securities and Exchange Commission. “Shedding Light on Dark Pools”.
- CFA Institute. “Dark Pool Trading System & Regulation”.
- U.S. Securities and Exchange Commission. “Regulation of Exchanges and Alternative Trading Systems: Final Rule”.
