Though they sound sinister in name, dark pools are merely private exchanges that are inaccessible to the public.
Because these liquidity pools are not transparent — like those found in a blockchain-based decentralized exchange or retail-facing centralized exchange — they are referred to as “dark” in order to describe their opaque nature.
Why were dark pools created?
Even though they operate outside of the normal retail investing sphere, dark pools serve an important purpose — namely, they provide institutional investors and high-net-worth individuals with the ability to make large block trades without adversely impacting the markets.
For example, whereas a multi-million dollar sale of Bitcoin (BTC) on a spot exchange would dramatically affect the price and create slippage, an over-the-counter sale via a dark pool would minimize slippage and keep the spot price of BTC relatively stable.
Before dark pools were created near the end of the 1980s, institutional investors and high-net-worth individuals had limited options for selling large amounts of shares — all of which involved splitting the entire sale into multiple orders of varying sizes in an effort to mitigate the on-exchange price impact of a stock.
However, mitigating the impact was nearly impossible on-exchange, where the identity of the seller — and, by extension, their intentions — were difficult to hide. Other traders were able to easily learn about the large intent to sell shares and follow suit, creating a price decline that negatively affected the original party looking to optimize its large sale.
The creation of more-secretive dark pools provided institutional investors and high-net-worth individuals an avenue for selling large amounts of shares without a trading floor finding out. The private nature of the trading directly correlates to the realization of a better average sale price — since retail traders are unlikely to find out about the sale and negatively affect the share prices by selling themselves.
In practice, this works because dark pool trades do not take place on a public order book. As such, the public is unable to see the existence of these large trades until much later.
Additionally, dark pools provide a place for similarly large buyers and sellers to come together since they are dedicated entirely to large investors and eschew small or medium-sized traders.
That said, dark pools are not impermeable to leaks. Information regarding a party’s intent to buy or sell a large amount of a share may be leaked — especially in an age when information travels fast — allowing non-dark pool and high-frequency traders time to front-run the trade.
Types of dark pools
Dark pools are not necessarily secretive in nature, despite their name. In fact, many dark pools are registered with financial authorities — such as the United States Securities and Exchange Commission, which defines three types of dark pools:
- Broker-dealer-owned dark pools
- Exchange-owned dark pools and agency broker dark pools
- Electronic market maker dark pools
Broker-dealer-owned dark pools
Broker-dealer-owned dark pools are constructed by broker-dealers looking to provide their clients with dark-pool solutions. Examples of such dark pools include CrossFinder from Credit Suisse, Sigma X from Goldman Sachs, and MS Pool from Morgan Stanley.
Exchange-owned dark pools
Exchange-owned dark pools are exactly what their name implies and may be found via BATs Trading, NYSE Euronext, etc. Likewise, agency broker dark pools — such as Instinet, Liquidnet, and ITG Posit — act as dark pool trading agents.
Electronic market maker dark pools
Finally, electronic market maker dark pools are operated independently.
Though many dark pools are registered with financial authorities, regulators still act with more suspicion when it comes to these opaque liquidity pools. Generally speaking, exchanges are treated more favorably by authorities, who are keen to keep the playing field as transparent as possible.
What are the disadvantages of dark pool trading?
While dark pools present many advantages to institutional investors and high-net-worth individuals, they are not without their flaws.
For example, dark pools may occasionally work against the participants’ best interests since there is no guarantee that a trade conducted in a dark pool was executed at the most favorable price. By contrast, the public nature of exchange’s order books generally prevents any surprises in this regard.
Additionally, though conflicts of interest may arise in any trading environment, dark pools’ opaque nature presents more opportunities for broker-dealers to trade against their clients or cut secretive deals with high-frequency traders looking to front-run major trades.
Indeed, front-running may be the biggest concern when it comes to dark pool participants. The financial markets have a long history of predators, and dark pools represent an ideal place for a front-runner to gain a first-mover advantage off of information intended to be kept out of the public’s purview.
Conclusion
Dark pools are private liquidity pools that provide a palace for institutional traders and high-net-worth individuals to facilitate large trades without the broader public market knowing in real-time. This allows the trades to be executed with minimal slippage and without other market participants affecting the price in a reactionary fashion.
However, dark pools are increasingly susceptible to information leaks. Such holes provide high-frequency traders with the opportunity to front-run dark pool trades. Additionally, the opaque nature of dark pools provides no guarantees that trades are executed at the best price.
Furthermore, though often registered with financial authorities, dark pools are generally treated with more suspicion by regulators.
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