What are Dark Pools?

Traditional trading in securities originated on the exchange floors, where traders would buy and sell orders amongst themselves, or on behalf of their clients, through telephonic conversations. Computerisation, in later years, helped manage the rising trade volumes with greater speed, accuracy and transparency. With rapid evolution in technology, online trading revolutionised the way the markets functioned. Real-time price dissemination, along with options to trade from anywhere and at any time made trading a viable profession for many young people, launching an era of “informal trading.”

Amidst all this, large financial institutions, in the late 1980s, were tempted to get into their own electronic trade matching and settlement systems. These private exchanges came to be known as “dark pools.”

Emergence of Dark Pool Liquidity

Dark pools were formed by large institutional traders, so that they could get into block trading, without affecting the markets with their huge orders. These were private electronic exchanges or forums for trading, not accessible to the retail investors. At the same time, they could also obtain adverse prices for their trades.

These exchanges are called “dark pools” because all the details regarding volume and price discovery are hidden from the public eye, until the trades are executed. Through high-frequency trading (HFT) technology, institutional traders can execute multi-million share block orders ahead of other retail traders, by leveraging on fractional changes in market prices.

These trades are so large, that they are impossible to carry out on public exchanges. Investment banks have, therefore, created their own private exchanges to facilitate large orders.

In the US, as of February 2019, there were more than 35 dark pools registered with the Securities and Exchange Commission (SEC). These off-exchanges combine together to make up 12% of the ADV in the US markets. Multiple dark pools have emerged in the European markets too, with a 2017 report by the European Central Bank stating that numbers have grown from less than 1% in 2009 to more than 8% of the total market liquidity in 2016.

But, with the growing emphasis on transparency and accountability in the global financial markets, the pros and cons of dark pools have been much debated in recent times.

Disadvantages of Dark Pools

Dark pools facilitate transactions that cannot be done on primary exchanges. They match two institutional investors, who might want to purchase or sell a large number of shares of a specific stock. But there is no guarantee that there will be a concomitant seller or buyer on the other side of the exchange. For example, a seller might be forced to sell in smaller blocks and wait till the next opportunity arises, during which time, the share price might decline.

Dark pools report transactions after trade execution. At the same time, they do not include the exchange fees and other costs related to traditional exchanges. As a result of this, prices can become distorted, since the price mechanisms are based on different information from that on public exchanges.

They are also poorly regulated. These exchanges can manipulate information flow, for the benefit of a few large companies or investment banks. Trading rules, method of price information and protection of proprietary data; all can be altered to suit certain big players only. Thus, market efficiency and fair competition are missing.

Lack of transparency and hiding of conflicts of interest are some of the reasons why many people are against dark pools. Often, large investors take advantage of HFT trading to place their order before a customer’s order, in order to leverage on the rise in prices, which has made the US SEC increase its vigilance over such predatory tactics.

Are There Advantages to Dark Pools?

Those in favour of dark pools maintain that they provide essential liquidity and help the markets run efficiently. The biggest advantage in this regard is that they significantly reduce market impact for large orders. Dark pools are completely opaque and not visible to retail traders, so large trades are executed without the average retail investor’s knowledge and leave limited impact on the public exchanges.

Many investors like to use dark pools, since competitors cannot see when they are executing large orders. Since these exchanges only have large institutional traders as participants, traders get more favourable prices than those on the public exchanges.

No exchange fees are levied on participants, which means significant cost savings over time. Orders crossed at the middle of the bid-ask price differences help in lowering costs associated with the spread.

The merits and de-merits of dark pools are debatable. While some say that they create efficiency and support competitive pricing, others say that the lack of transparency in these markets is a threat to the overall financial stability. This can add complexity in the markets, which are already struggling amidst an economic slowdown.

Types of Dark Pools

Dark pools have broadly been classified into three categories:

1.       Exchange-Owned

These are the ones that do not act as principals, but as agents. Prices are derived from other exchanges, so there is no element of price discovery. They are also called “agency broker” dark pools. NYSE Euronext and Liquidnet are some examples of these dark pools.

2.       Electronic Market-Makers

These dark pools are owned by independent operators, who act as principals for their own account trading. Here, transaction prices are not derived from other exchanges, so there is price discovery. Dark pools owned by Getco and Knight can be considered as examples here.

3.       Broker-Dealer Owned

A majority of dark pools fall under category. They are set up by large broker-dealers for clients and their own proprietary traders. They derive their own prices from order flow. Credit Suisse’s CrossFinder and Morgan Stanley’s MS Pool can be considered as some examples of this type of dark pool.

Dark pools are not illegal per se. They can offer significant cost advantages to buy-side companies like pension funds and mutual funds. However, they do attract a lot of attention from regulatory bodies due to unfair HFT practices, which poses a threat to their long-term relevance. Flash trading, where a few privileged traders are able to take advantage of market sentiment, brings risks, typically those seen before the global financial crisis of 2008.

Investors should go through all established guidelines before participating in these pools.

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