Dark pools, sometimes referred to as “dark pools of liquidity,” are a type of alternative trading system used by large institutional investors to which the investing public does not have access.
Living up to their “dark” name, these pools have no public transparency by design. Institutional investors, such as mutual fund managers, pension funds, and hedge funds, use dark pool trading to buy and sell large blocks of securities without moving the larger markets until the trade is executed.
Who Runs Dark Pools?
Investment banks typically run dark pools, but some other institutions run them as well, including large broker-dealers, agency brokers, and even some public exchanges. Some trading platforms, where individual investors buy and sell stocks, also use dark pools to execute trades using a payment for order flow.
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There were more than 50 dark pools registered with the Securities and Exchange Commission (SEC) in the United States in 2020. The role of dark pools in the market varies over time. At the start of 2021, it comprised half of trades in a single day, but a few months later that share had fallen to 12.91% of U.S. equity volume.
Because trades in a dark pool aren’t reflected in the prices on a public exchange, participants in a dark pool trade based on the prices offered on a public exchange, using the midpoint of the National Best Bid and Offer (NBBO) to set prices.
Why Institutions Use Dark Pools
Large, institutional investors such as hedge funds, may turn to dark pools to get a better price when buying or selling large blocks of a single stock. That’s because of the way that large trades impact the public markets.
If a mutual fund manager, for example, wants to sell a million shares of a given stock because it’s underperforming or no longer fits their strategy, they’d need to use a floor trader to unload the position on a public exchange. Selling all those shares could impact the price they get, driving down the VWAP (volume weighted average price) of the total sale.
To avoid driving down the price, the manager might spread out the trade over several days. But if other traders identify the institution or the fund that’s selling they could also sell, potentially driving down the price even further.
The same risk exists when buying large blocks of a given security on a public market, as the purchase itself can attract attention and drive up the price.
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New Risks
The risks of attracting attention from other traders have intensified with the rise of algorithmic trading and high-frequency trading (HFT). These strategies employ sophisticated computer programs to make big trades just ahead of other investors. HFT programs flood public exchanges with buy or sell orders to front-run giant block trades, and force the fund manager in the above example to get a worse price on their trade.
But with a dark trade, that institutional investor can sell a million shares of a stock without the public finding out because dark pool participants don’t disclose their trades to participants on the exchange. The details of trades within a dark pool only show up after a delay on the consolidated tape – the electronic system that collates price and volume data from major securities exchanges.
There are other advantages for an institutional trader. Because the buyers and sellers in a dark pool are other institutional traders, a fund manager looking to sell a million shares of a given stock is more likely to find buyers who are in the market for a million shares or more. On a public exchange, that million-share sale will likely need to be broken up into dozens, if not hundreds of trades.
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Criticism of Dark Pools
As dark pools have grown in prominence, they’ve attracted criticism from many directions, and scrutiny from regulators.
The lack of transparency in dark pools and the exclusivity of their clientele makes some investors uneasy. Some even believe that the pools give large investors an unfair advantage over smaller investors, who buy and sell almost exclusively on public exchanges.
The Takeaway
While as an individual investor you can’t trade directly in dark pools, you can still get started with your investment journey. An easy way to begin is by opening an account with the SoFi Invest® brokerage platform. SoFi Invest offers an active investing solution that allows you to choose your stocks and ETFs without paying commissions. SoFi Invest also offers an automated investing solution that invests your money for you based on your goals and risk, without charging a SoFi management fee.
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