What Are Dark Pools How They Work Critiques and Examples

Jonathan is the President of Boyar’s Intrinsic Value Research LLC, an independent research boutique.

A dark pool is a privately organized financial forum or exchange for trading securities. It allows institutional investors to trade without exposure until after the trade has been executed and reported. Dark pools are alternative trading systems (ATS) that give certain investors the opportunity to place large orders and make trades without publicly revealing their intentions during the search for a buyer or seller.

Dark pools are private asset exchanges designed to provide liquidity and anonymity for trading large blocks of securities away from the public eye. They provide pricing and cost advantages to buy-side institutions such as mutual funds and pension funds, which claim that these benefits ultimately accrue to retail investors.

Dark pools emerged in the 1980s when the Securities and Exchange Commission (SEC) allowed brokers to transact large blocks of shares. Electronic trading and an SEC ruling in 2005 that increased competition and cut transaction costs have stimulated an increase in the number of dark pools. Dark pools can charge lower fees than exchanges because they are often housed within a large firm, not necessarily a bank.

For example, Bloomberg LP owns the dark pool Bloomberg Tradebook, registered with the SEC. Dark pools were initially used by institutional investors for block trades involving a large number of securities. However, dark pools are no longer used only for large orders. A 2013 report by Celent found that block orders moving to dark pools caused the average order size to drop about 50%, from 430 shares in 2009 to approximately 200 shares in four years.

The primary advantage of dark pool trading is that institutional investors making large trades can do so without exposure while finding buyers and sellers. This prevents heavy price devaluation. If, for example, it were public knowledge that an investment bank was trying to sell 500,000 shares of a security, the security would almost certainly have decreased in value by the time the bank found buyers for all of their shares. Devaluation has become an increasingly likely risk, and electronic trading platforms are causing prices to respond much more quickly to market pressures. If the new data is reported only after the trade has been executed, however, the news has much less of an impact on the market.

With the advent of supercomputers capable of executing algorithmic-based programs in milliseconds, high-frequency trading (HFT) has come to dominate daily trading volume. HFT technology allows institutional traders to execute orders of multimillion-share blocks ahead of other investors, capitalizing on fractional upticks or downticks in share prices. When subsequent orders are executed, profits are instantly obtained by HFT traders who then close out their positions. This form of legal piracy can occur dozens of times a day, reaping huge gains for HFT traders.

Eventually, HFT became so pervasive that it grew increasingly difficult to execute large trades through a single exchange. Because large HFT orders had to be spread among multiple exchanges, it alerted trading competitors who could then get in front of the order and snatch up the inventory, driving up share prices. All of this occurred within milliseconds of the initial order being placed.

Although considered legal, anonymous trading in dark pools is able to operate with little transparency. Those who have denounced HFT as an unfair advantage over other investors have also condemned the lack of transparency in dark pools, which can hide conflicts of interest. Due to complaints, the SEC conducted research and presented their 2015 report, scrutinizing dark pools for illegal front-running when institutional traders place their order in front of a customer’s order to capitalize on the uptick in share prices. Advocates of dark pools insist they provide essential liquidity, allowing the markets to operate more efficiently.

There are several types of dark pools: broker or dealer-owned exchanges like Morgan Stanley’s MS Pool and Goldman Sachs’ Sigma X; independently owned exchanges offering private trading to their clients; and private exchange markets operated by public exchanges like the New York Stock Exchange’s Euronext. A privately-owned market will have price discovery within their own markets, but a dark pool operated by a broker derives its prices from public exchanges.

Because of their sinister name and lack of transparency, dark pools are often considered dubious enterprises by the public. In reality, they are tightly regulated by the SEC. However, there is a concern that because of the sheer volume of trades conducted on dark markets, the public values of certain securities are increasingly unreliable or inaccurate. There is also a mounting concern that dark pool exchanges provide excellent fodder for predatory high-frequency trading.