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.
Understanding the History of Dark Pools
The history of dark pools in the trading world starts in the 1980s, following changes at the Securities and Exchange Commission (SEC) which effectively allowed brokers to make trades in large share blocks. Later, in the mid-2000s, further SEC changes that were meant to cut trading costs and increase market competition led to an increase in dark pool trading.
Dark Pool Examples
There are many dark pools out there, and they can be operated by independent companies, brokers or broker groups, or stock exchanges themselves. An internet search would bring up names of specific dark pools.
But to get a sense of how a dark pool can be used to investors’ benefit, say there’s a mutual fund looking to sell 2 million shares of Stock X. Given that selling that amount of shares would create ripples in the market, the mutual fund may not want to sell them all at once. As such, they sell them in blocks of 10,000, 1,500, or 5,000 shares — and find buyers for the smaller blocks accordingly.
This method makes it less obvious that a huge number of shares are being sold, which could avoid Stock X’s shares losing value quickly.
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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The role of dark pools in the market varies over time. At times, dark pool trades comprise as much as half of all trading in a single day, while at other times, they make up significantly less 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.
💡 Quick Tip: Look for an online brokerage with low trading commissions as well as no account minimum. Higher fees can cut into investment returns over time.
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.
As discussed, 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.
Dark Pool Benefits
Utilizing a dark pool and conducting a dark trade, institutional investors 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.
Criticism of Dark Pools
As dark pools have grown in prominence, they’ve attracted criticism from many directions, and scrutiny from regulators. For instance, 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.
💡 Quick Tip: Investment fees are assessed in different ways, including trading costs, account management fees, and possibly broker commissions. When you set up an investment account, be sure to get the exact breakdown of your “all-in costs” so you know what you’re paying.
The Takeaway
As discussed, dark pools are sometimes referred to as “dark pools of liquidity,” and are a type of alternative trading system used by large institutional investors to which the investing public does not have access. They’re typically run and utilized by large investment banks.
Given the nature of dark pools, they attracted criticism from some due to the lack of transparency, and the exclusivity of their clientele. While the typical investor may not interact with a dark pool, knowing the ins and outs may be helpful background knowledge.
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FAQ
How can you see dark pool trades?
Investors can access dark pool trading data through various securities information processors, and can be accessed through FINRA’s website as well.
Who regulates dark pools?
The Securities and Exchange Commission, or SEC, is the government body that regulates dark pools and dark pool trading.
What are dark pools in cryptocurrency?
A dark pool in cryptocurrency is more or less the same as a dark pool in other equities markets, and is a place that matches buyers and sellers for large orders outside of a public exchange or view.
How do dark pools differ from lit pools?
As many might surmise, lit pools are effectively the opposite of dark pools, in that they show trading data such as number of shares traded and bid/ask prices.
Photo credit: iStock/DNY59
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