Most people find “Dark Pools” very mysterious. In fact, most people don’t even know what they are. Basically, “dark pool” is Wall Street slang for a type of private stock trading platform.
Dark Pools are electronic Alternative Trading Systems, the are in fact very similar to stock exchanges where trades can be matched. The main difference is in dark pools, the price at which shares are offered for sale cannot be seen by anyone – even those participating in the exchange. The price at which shares change hands is only disclosed after the trade is completed. This limits the amount of interaction between participants as the participants don’t know when to move their price up or down in answer to the trade. These pools are largely used by sophisticated professional traders.
With the recent controversy surrounding dark pools, it may be useful to clarify not only what dark pools are but also what they are not. This article looks at the common perceptions of dark pools and aims to shed some light on their murky waters.
They are not a “Black Market,” trading platform. The prices and size of trades just aren’t displayed. A dark pool allows traders to buy or sell large amounts or ‘blocks’ without other traders knowing that the sale is being made. This prevents other traders from putting the price up or down and minimizes the block trade’s effect on the market. The way dark pools are sometimes portrayed in the media makes them seem like a rogue activity operating in a legal vacuum where everyone stands to make millions. This is not the case.
Dark Pools are not new. They have been around since trading began. The simple fact is that the term ‘dark pool’ is relatively new – it was previously called ‘upstairs trading’. They are not damaging to the stock market.The Securities and Exchange Commission has recognized the importance for institutions to be able to work orders without displaying the whole order “to maintain long term confidence” in the markets.
Dark Pools are not unregulated. In fact they are very highly regulated. All Dark Pools are broker-dealers registered with the SEC and The Financial Industry Regulatory Authority (FINRA) and subject to regular audits and examinations.
They are not environments where the participants ‘go in blind’. Participants choose to place their orders in a Dark Pool. The users are sophisticated traders who understand the advantages of not displaying their orders at an exchange. Dark Pool prices are not ‘just made up’. Dark Pool trades are bound by the National Best Bid and Offer. Prices cannot be chosen arbitrarily, often the price is actually the midpoint of the NBBO but a stock cannot trade outside the NBBO without an inter-market sweep satisfying orders on other markets.
They are not a strange occurrence, nor on the decline. Dark pools have become more widely used due to technological advancements that have lowered costs allowing brokers and dealers to route more of the order flow they handle to their own private pools first before sending unwanted orders to the public markets. The volume of trade in Dark Pools is increasing because the system really works for institutions. The percentage of non-exchange trades has grown to roughly 33 percent of all trades up from 8-10 percent a decade ago. The reason for this is that users may have had a better experience and more success, using dark pools than regular exchanges.
Dark Pools are not all the same. Dark Pools have varying features to appeal to different segments of the market. Some only allow certain types of traders, others allow particpants to rank trading partners and opt out of those they don’t want to trade with. The main purpose of dark pools is to minimise market impact. By restricting access to undesirable market participants for example, high frequency trading firms, and by not revealing prices, dark pools enable institutional investors to minimise their information disclosure and realise more efficient executions. More precisely, dark pools create the possibility of price improvement and lesser transaction costs by crossing orders at the midpoint of the quoted best bid and offer prices, which saves on both the bid-offer spread and on exchange fees. These are the reasons dark pools are so popular for large, block trades. and they is a more tailored experience to that of the exchange.
The main criticisms of dark pools are that they lack transparency and that they will inevitably cause fragmentation would may lead to less efficient pricing in traditional open stock exchanges. Last year, in the United States,the CEO’s of NYSE Euronext, Nasdaq OMX and BATS Global Markets urged regulators to introduce rules permitting trades to only take place away from a public exchange if a customer is getting an improved price. They looked at steps taken by Canadian and Australian regulators to fight the rise of dark pools.Both Barclays and Goldman Sachs have been successfully sued in connection with dark pool activity. Due to increased criticism and legal activity, in recent months some dark pools have voluntarily published information on how they operate.
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