What is a “dark pool”?

September 13, 2021

Category:

3 min read

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Origins

In 2017, according to the CFA Institute, 40% of stock trades in the US occurred off public stock exchanges. This represented a surge, from the 2010 level of 16%. A significant portion of this happened within ominous sounding dark pools, so named for their lack of transparency.

Overview

Dark pools of liquidity are private marketplaces for the trading of large volumes of securities. They came into existence in the 1980s as a way for investors to sell a large block of shares for a fair price. As of February 2020, there were more than 50 registered with the Securities and Exchange Commission (SEC) in the US. These are owned and operated by a variety of different institutions, particularly broker-dealers, such as Goldman Sachs and Morgan Stanley, and exchanges, such as NYSE Euronext and BATS Trading.

Prior to their invention, the options for an investor who wished to sell a large stake were limited and often involved sacrificing significant value, as the volume of shares suddenly injected into the market would drag the price down. Other traders may follow suit, pushing the price down even further. In order to avoid this, a trader would have to unwind their position over a long period so as to avoid upsetting the market and even this would likely deflate the price somewhat.

Instead, an institutional investor who wishes to sell, for example, one million shares of Company A, may use a dark pool. In this scenario, they do not need to disclose their trading intention to the exchange, on which Company A trades publicly. This means that the trade does not appear in publicly available order books, and thus does not affect the price of the stock. The details of the trade, instead, are made public only after the trade has taken place. In a dark pool trade, the entire block can be sold to a single buyer, as they are exclusively available to large scale investors.

As well as the diminished market impact, there are other advantages to dark pools, such as reduced transaction costs, as there are no exchange fees to pay. These can be considerable in trades of hundreds of thousands or millions of shares. Most of these advantages remain with big institutional investors, however, they argue that the benefits are passed on to retail investors who own these funds.

However, there are also significant disadvantages or worries. One key concern is that the price of a stock collapses once a dark pool trade is made public. If the stake is large enough, it could destroy investor confidence in the stock. Another concern is that exchanges may cease to reflect the true market price of a stock, if dark pool trading increases. This would happen if institutional investors began to trade more heavily in dark pools than on exchanges, by reducing the frequency of trades on the market.

High frequency traders (traders who use computer algorithms to make huge numbers of trades in a fraction of a second) have also reportedly taken advantage of dark pools, by discovering large hidden trades and “front-running”. This is an illegal process by which a trader takes advantage of non-public information about a future trade which will affect the price of a security.

Verdict

Regulators have always eyed dark pools with suspicion, owing to their opacity, but with these more recent developments, they have turned their attention to dark pools. One proposal by the SEC is to require brokerages to execute client trades on exchanges, unless the price obtained in a dark pool is substantially better than the one which they could achieve on the public market. This could drastically reduce the amount of trading occurring in dark pools.

However, across the Atlantic, free from restrictive EU rules regarding dark pools, Britain is reportedly considering relaxing its attitude towards them. This is one way in which Britain could advance its policy of becoming a more investor-friendly system following Brexit, allowing the UK to maintain its position as a global financial hub.

Report written by Joshua White

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