Genuinely, dark pools are private stock exchanges inaccessible to the general investing public. These exchanges are often called dark pools of liquidity, referencing their utter lack of transparency. Moreover, they were created to assist block trading by institutional investors who did not want their massive orders to negatively influence the markets or result in bad pricing. Therefore, it is very interesting to explore more about them, which you can learn in this article.
List of Contents
What Exactly Is a Dark Pool?
A dark pool refers to an unregulated market where investors may buy and sell stocks without anybody else knowing about it. Institutional investors can trade in it without risking disclosure until the deal is completed and reported. When searching for a buyer or seller, investors using dark pools might avoid disclosing their true intentions, keeping their transactions and orders private.
How Did Dark Pools Originate?
Dark pools were established after a 1979 regulation adjustment by the Securities and Exchange Commission (SEC). Traders wanted cheaper execution costs and did not want their competition to know what, when, how much, and how many instruments they were trading. As a result, they were established so that pricing would not be made public. Significantly, the first of them was established in 1986, when Instinet launched its trading platform After Hours Cross. It lets investors make anonymous orders executed after the markets have closed. In 1987, ITG’s POSIT was introduced as the second platform. According to a 2015 research report by Credit Suisse, the growth of them can be attributable to regulatory alterations, better trading systems, and a drop in market volatility.
Moreover, Regulation ATS established a framework to facilitate the integration of dark pools into the existing market system and to relieve regulatory concerns over their use. In 2005, the SEC issued Regulation NMS and enabled automated New York Stock Exchange (NYSE) trading. In addition to these critical regulatory improvements, financial communications technology has accelerated the development of innovative hybrid approaches like flash and algorithmic trading, which use speed, huge order volumes, and liquidity to control trading costs. All of them were available, but issues quickly arose. The flash collapse of 2010, which lasted around 36 minutes and wiped away over $1 trillion in market value, demonstrated the need for tighter regulation to manage high-frequency trading.
Working Principles of Dark Pools
Five non-regulatory variables influence the development of them are as follow:
- Lowered transaction fees
- Lower market volatility
- Greater trader autonomy More efficient trading
- The necessity to prevent technical trading mistakes
The popularity is also attributable to their specialized trade execution forms and specializations. Most of them operate as an electronic limit order book market. Some platforms run continuously throughout the day, while others are block trading-cross platforms. Some are non-displayed limit order books. Some execute orders at the midpoint of the exchange, while others quickly accept or reject orders. Additionally, they charge lesser fees than conventional exchanges.
3 Types of Dark Pools
1. Electronic Market Makers Dark Pools
Independent operators, such as Getco and Knight, provide these dark pools, which act as principals for their accounts. As with broker-dealer-owned them, transaction prices are not derived from the NBBO. Therefore price discovery occurs.
2. Agency Broker or Exchange-Owned Dark Pool
They are agents, not principles. There is no price discovery since prices are generated from exchanges, such as the National Best Bid and Offer (NBBO) midpoint. Instinet, Liquidnet, and ITG Posit are examples of agency broker, whereas BATS Trading and NYSE Euronext are exchange-owned them.
3. Broker-Dealer-Owned Dark Pool
Large broker-dealers establish these dark pools for their clients, which may contain their proprietary traders. They determine their pricing based on order flow. Therefore price discovery is a factor. Credit Suisse’s CrossFinder, Goldman Sachs’ Sigma X, Citibank’s Citi-Match, and Morgan Stanley’s MS Pool are examples of them.
Dark Pools and High-Frequency Trading
High-frequency trading (HFT) has grown to dominate daily trade activity with the introduction of supercomputers capable of executing algorithmic-based programs in milliseconds. HFT technology enables institutional traders to execute orders for multimillion-share blocks before other investors. Thus, it profits on fractional increases or decreases in share prices. When successive orders are completed, HFT traders profit instantly and shut down their holdings. This legal theft can occur hundreds of times daily, providing HFT traders with enormous profits. Eventually, HFT got so prevalent that executing big deals on a single exchange became impossible. HFT orders must be spread over several exchanges, alerting trading competitors who may swoop in and grab the inventory, raising share prices. All of these events transpired just milliseconds after the first order was placed.
In addition, some investment institutions created dark pools and secret exchanges to avoid public exchange transparency and retain liquidity for big block trades. They provide liquidity with large orders for traders who cannot place them on normal exchanges or want to hide their intentions. As of February 28, 2022, 64 of them were functioning in the United States, most of which were managed by investment banks.
Regulation of Dark Pools
Recent HFT controversies have generated major regulatory interest in dark pools. They have traditionally been viewed with distrust by regulators due to their lack of transparency. This debate might prompt renewed efforts to limit their popularity. A pilot plan by the Securities and Exchange Commission (SEC) to implement a trade-at regulation may help exchanges regain market share from them and other off-exchange venues. Unless they outperform the public market, brokerages must send customer trades to exchanges instead of dark pools. This regulation, if enforced, might pose a significant threat to the long-term existence of them.
The Impact of Dark Pools on Individual Investors
While the dark pool market has grown, its influence on public stock exchanges, where most individual and retail trading occurs, remains unclear. The increasing popularity of cryptocurrencies has authorities concerned about market quality, price improvement, and market integrity. In 2018, the SEC approved Rule 304 as an update to Regulation ATS, mandating the reporting of Form ATS-N, which contains several dark pool disclosures.
Benefits and Drawbacks
Benefits
The greatest benefit is that huge orders have a much-diminished market impact. Dark pool trades do not incur exchange fees, and transactions based on the bid-ask midpoint do not incur the whole spread. If trading operated by broker-dealers and electronic market makers continues to increase, stock prices on exchanges may not accurately reflect the market. For instance, if a reputable mutual fund holds 20% of the firm RST stock and sells it, the fund may receive a favorable price. However, investors who recently purchased RST shares will have overpaid since the price might drop once the sale of the fund becomes public knowledge.
As there is no assurance that the institution’s deal was performed at the lowest price, the lack of transparency can also operate against pool participants. Despite having a modest share of the U.S. market, the broker-dealer internalizes many trades. If a broker-proprietary dealer’s traders trade against clients or if it gives HFT enterprises exclusive access to it, the opaqueness might cause conflicts of interest.
Drawbacks
While regulated dark pools are lawful and governed by the SEC, they have been criticized for their lack of transparency. Since trades are not exposed to the public, high-frequency trading companies often utilize them for predatory behaviors. They employ techniques like pinging to discover massive secret orders and engaging in front-running or latency arbitrage.
In addition, dark pool operators have been accused of exploiting the data to trade against their clients or misrepresenting the pools. The Wall Street Journal reports that since 2011, securities authorities have recovered more than $340 million from dark pool operators to resolve different legal claims. The average transaction size in dark pools has fallen below 150 shares. The New York Stock Exchange (NYSE) and other exchanges losing market share to dark pools and alternative trading platforms argue that the small size of these deals makes dark pools less persuasive.
Conclusion
In short, dark pools give buy-side institutions like mutual funds and pension funds pricing and cost benefits, which they hope will benefit investors. However, the lack of transparency of dark pools leads to conflicts of interest by their owners and predatory trading by HFT corporations. They are under scrutiny due to high-frequency trading, and the planned trade legislation might undermine their long-term viability.
FAQs
Contrary to their name, they are not necessarily forbidden. However, there have been cases of dark pool operators engaging in unethical or illegal trading. Credit Suisse was fined over $84 million in 2016 for trading against its clients using its dark pool. Barclay’s Capital, another operator, paid $70 million. Some have claimed that they contain inherent conflicts of interest and should be controlled more strictly.
Like stock market pools, Cryptocurrency dark pools link buyers and sellers for big orders without a public order book. Nonetheless, Bitcoin dark pools may be decentralized through smart contracts. Buyers and sellers use blockchain-based software to trade without disclosing sensitive information.
The purpose of dark pools is to lessen volatility by concealing huge trades. Large block sales tend to reduce the stock price on the open market by increasing the accessible supply of the asset. They let large institutional holders purchase or sell huge amounts without disclosing market-affecting information.
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Source: Investopedia