What is a Dark Pool?

There are terms in the world of finances that do not sound as threatening and ominous as a ‘dark pool’. Upon first glance, it would be easy to assume that these pools correlate with the darknet. Perhaps it is just another tool that aids in the act of illicit trading in the deep web.

In reality, these assumptions are not true. Dark pools have absolutely no involvement with the dark web, nor are they associated with the black market. It’s no surprise that dark pools became an extremely misunderstood aspect of traditional financial markets. These misconceptions are unfair, but with a name like ‘dark pool’, they are inevitable.

Dark pools are specifically for private exchanges or forums that are suitable primarily for securities trading. Unlike stock exchanges, the investing public is unable to access dark pools. Also going by the name ‘dark pools of liquidity’, these exchanges are notable for their complete lack of transparency. The purpose of the creation of dark pools focuses chiefly on facilitating block trading by institutional investors. Specifically, investors who don’t want to impact the markets with their large orders and acquire conflicting prices for their trades.

Michael Lewis’ bestseller, Flash Boys: A Wall Street Revolt, was responsible for dark pools being cast into an unfavorable light. In actuality, these pools serve a purpose. With that said, their lack of transparency leads to them being susceptible to potential conflicts of interest. Those making these conflicts are their owners, as well as predatory trading practices by some high-frequency traders.

Breaking down the name

Before we get into what exactly dark pools are, we must first break down the name. The purpose of this is to properly clarify why it has this ominous-sounding name in the first place.

First and foremost, put aside the word ‘pool’, as that is simply a finance-slang for a market. It is quite common so there is no need to go into too much detail about it here. Instead, we will focus on the meaning behind the word ‘dark’.

Now, a ‘dark market’ is a trading venue that does not put the bids or offers (asks) on display. Bids or asks exist, obviously, but they are always concealed inside a dark market. In contrast to this, markets that display their bids and asks goes by the name ‘lit’. Next, the reason behind replacing the word “exchange” with “pool” is to separate the specific set of users from the larger available liquidity. However, the key concept here is ‘darkness’.

Darkness is indicative of the absence of visible bids and offers; it does not insinuate the omission of trade reports. It is mandatory for there to be a report of trades in many regions. In the U.S., the reports of trades must be to the proper Trade Reporting Facility, albeit with a delay.

When dark pools come up in discussion, especially in the context of cryptocurrency, there is always one particular dominating assumption. That being these dark markets would operate solely as continuous non-displayed limit order books. In the world of the traditional markets, however, a small portion of dark pools actually operate in this fashion. Dark pools will frequently derive their pricing from lit exchanges. Moreover, a majority of the volume trades at the National Best Bid and Offer (NBBO) mid-price.

What are they?

Dark pools are private financial forums or exchanges that are predominantly for trading securities. These pools are what allow investors to trade without exposure until the aftermath of the trade’s execution. Dark pools are a type of ‘alternative trading system’, which are systems not regulated as an exchange. However, they are venues to match the buy and sell orders of subscribers. Dark pools permit investors to place orders and conduct trades without publicly revealing their intentions during the search for a buyer or seller.

Dark pool trades are ‘over-the-counter’ creations, meaning that the trading of the stocks is directly between the buyer and seller. Most of the time, this is accomplished with the aid of a broker. Public exchanges, such as the New York Stock Exchange (NYSE), rely heavily on centralized pricing. Conversely, over-the-counter traders achieve their price agreements in a more private manner.

There are three common types of dark pools:

  1. Broker-dealer owned
  2. Agency broker or exchange-owned
  3. Electronic market makers

The establishment of the first type is by broker-dealers for their clients. They will sometimes include proprietary trading. These prices stem primarily from their own order flow. The second type functions as an agent rather than a principal. There are no price discoveries due to the fact that the prices come from exchanges. The last type is one that independent operators offer and there is no price discovery with this type.

Dark pool exchanges preserve their confidentiality because of this over-the-counter model. With it, neither party needs to publish any identifying or price information. That is unless there are specific conditions that compel them to. A public institution, for example, might have to disclose this information because of disclosure laws that have nothing to do with the dark pool.

What is the purpose of their existence?

Now that we know what they are, we should look into why they exist at all. What is their reason for being? The answer for that is tied to large scale investors. Dark pools exist mainly for the investors that have no desire to influence the market by way of their trades.

The potential influence they could have on the market is what is commonly referred to as the ‘Icahn Lift’. The name of this concept comes from the legendary investor, Carl Icahn. Icahn can supposedly leave an impact on the price of a stock just by purchasing it. The titular “lift” stems from other investors seeing Icahn’s interest and subsequently jumping in. This effectively results in the stock price rising. Many view him as being a one-man bull market.

This type of thing happens to large scale investors as well. Whenever an institutional investor wishes to shift assets, it risks creating a price swing. This is largely due to other investors seeing the interest (or disinterest) and reacting accordingly. Most of the time, this is not good.

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Spiraling prices from large purchases

Imagine a trader who is known for takeover bids. Should they start purchasing shares of stock in a company, then other traders will assume that they anticipate an acquisition. This could result in a mad dash to buy the stock. Doing so will skyrocket its price and make the takeover more costly.

Alternatively, imagine a company in the middle of a share buyback. The board doesn’t want to enrich itself; all they want is to reconstruct the company. Though, as the company starts buying all of its shares off the market, the price will spiral. This will lead to an increase in expenses and potentially debt.

Typically, a public exchange will publish all of this information through its central marketplace. Investors are able to either take note of the takeover or share buyback in progress. This will result in them wanting to trade accordingly. On a dark pool, these parties are able to keep things on the down-low for a little while longer. Hopefully, they will encounter any spiraling prices.

Falling prices from large sales

Let’s imagine a mutual fund wanting to sell 1.5 million shares of a company. The odds of the fund selling all of these shares at once are very slim. In lieu of this, it will have to sell in parcels. In other words, finding a buyer for specific amounts of shares here and there.

As soon as the market hears that the mutual fund is liquidating its shares, the price will instantly decrease. The abrupt rush of accessible stock will force its price downward. If this fund is well-respected, then the lack of public confidence might devalue the stock price further. Because of this, every new buyer will pay less for each parcel of the mutual fund’s stock.

The new surrounding this would get out on a public exchange almost immediately. With a dark pool, the mutual fund can attempt to sell off its shares. It can do so without ever alerting the market and leading to a complete run on the company’s stock.

Why use them?

The absence of transparency of dark pools is indeed something to be wary of. After all, it renders them vulnerable to potential conflicts of interest, as mentioned earlier. However, as difficult as it may be to believe, there is a perk that comes from this seemingly adverse quality.

This lack of transparency works in the institutional investor’s favor. This is because it could result in a better-realized price than if the execution of the sale was on an exchange. Due to dark pool participants not disclosing their trading intentions to the exchange, there is no publicly visible order book. The release of the details concerning trade execution is strictly to the consolidated tape following a delay.

The institutional seller will have a better chance of tracking down a buyer for the full share block in a dark pool. This is due to the fact that it is a forum that is primarily for large investors. The odds of price improvement are pretty high. However, this is only if the mid-point of the quoted bid and ask price is used for the transaction.

Evidently, this is under the assumption that there is no leaking of the investor’s proposed sale information. Furthermore, the dark pool is not susceptible to high-frequency trading (HFT) predators. These predators could potentially partake in front-running as soon as they take note of the investor’s trading intentions.

Pros & Cons of Dark Pools

There are advantages to using dark pools:

  • There is a reduction in market impact. This is probably the biggest advantage of dark pools. The overall market impact diminishes significantly for large orders.
  • The transaction costs are lower. Dark pool trades do not have to pay exchange fees, while transactions drawing from the bid-ask midpoint don’t provoke the full spread. Thus, costs for transactions will be a lot lower.

With all the perks that come from using dark pools, there are also disadvantages:

  • Exchange prices will likely not reflect the real market. Suppose that the amount of trading in dark pools that broker-dealers and electronic market makers own will grow continuously. If so, then stock prices on exchanges will not factually reflect the market.
  • It’s unlikely that pool participants will receive the best price. The lack of transparency in dark pools could work against a pool participant. There is no concrete guarantee that the execution of the institution’s trade was at the best price.
  • There is a strong vulnerability to predatory trading by HFTs. A bulk of the controversy over dark pools is thanks to Lewis’ aforementioned bestseller. He claims that dark pool client orders are ideal for predatory trading practices by various HFT firms.
  • The small average trade size greatly reduces the need for dark pools. The average trade size in dark pools has dropped to roughly 200 shares. Certain exchanges like the NYSE claim that this small trade size proves that dark pools are less compelling.

The general impact

In the end, there is one question that remains: are dark pools beneficial for the market? Moreover, are they good for retail, institutions, and retail because they are good for institutions? There is no definitive answer other than “probably.”

Market fragmentation – the same product trading in numerous places and on an array of venues – speaks to blockchain’s core values. Those being decentralization, anti-fragility, and independence from gatekeepers. Diverse platform types are optimal for different variations of traders. Moreover, participants are able to self-select where exactly they should trade.

Electronic trading is surprisingly not that old of a practice. In fact, one can trace its origins back to the early 90s. There is no discernible reason to speculate that the current designs and mechanics of exchanges are accurate. Surrogate designs and rules have the potential to be superior. Diversity is a key ingredient in markets. That same diversity is also beneficial for crypto markets.

The dynamics among these types of traders – like retail and institutional – and traditional liquidity providers are incredibly complex. Overall, it is impossible to apply cause and effect in a clear-cut manner. This is especially true in relation to the continuously shifting and evolving mechanics. Whether or not we will solve this complexity is something that only time will tell.

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