Understanding Dark Pools

What are dark pools?

A dark pool offers the same function as your typical financial exchange markets but with a few very stark differences. Where your typical financial exchange markets are strictly regulated, dark pools are not. The main function of dark pools is to allow investors to trade without any public exposure until after they have executed and cleared their trade. 

This serves major hedge funds that are trying to keep their positions hidden from the public. For example, if they are looking to short a company’s stock, using dark pools would help them to keep that information private so as to not influence other traders. 

As trading has become more electronic in nature these days, it has given rise to plenty of exchange platforms. In addition to exchanges that are run by institutional banks, we have now seen a progessive rise in dark pools as well. 

These dark pools provide users with the opportunity to trade securities on a secondary market with much lower fees. For the most part though, we still predominantly see dark pools being used by institutional investors who are executing block trades when taking up a large investment position. 

Block trading

Block trading or block trades is simply a large number of securities being traded between two parties. While there may not be any specific parameters for a block trade, it’s widely understood to be trades that are so large that they actually have an impact on the price of a security. 

While everyday traders who buy and sell securities will not have the spending power to move the price of a security, these larger hedge funds and institutional investors that trade amongst themselves are trading in such large quantities that they can actually shift the price point of the security they are trading.

Different types of dark pools

The SEC (Securities and Exchange Commission) has currently documented a total of 60 dark pools that are available for use right now. However, not every one of these dark pools are unique. Each dark pool falls into a category of its own, namely 3 the different types of dark pools. Let’s take a look at the kinds of dark pools one can use.(1)U.S. Securities and Exchange Commission."Alternative Trading System ("ATS") List."

Exchange-owned dark pool

An exchange-owned dark pool or an agency broker is a dark pool that functions as an agent, as opposed to a principal. Prices are taken from the exchanges themselves which means that there is no price discovery. Examples of exchange-owned dark pools or agency brokers include:

• Instinet 
• ITG Posit
• Liquidnet
• NYSE Euronext
• BATS Trading

Broker-dealer-owned dark pools

Where an exchange-owned dark pool does not have a price discovery, there is at least some element of price discovery with a broker-dealer-owned dark pool. This is because the prices are derived from the order flow. Another key difference here is that these dark pools are set up by broker-dealers for their clients and they can, at times, include prop trading. Examples of broker-dealer dark pools include: (2)Congressional Research Service."Dark Pools in Equity Trading: Policy Concerns and Recent Developments,"

• Citibank’s Citi-Match
• Morgan Stanley’s MS Pool
• Credit Suisse’s CrossFinder 
• Sigma X 
• Goldman Sachs’ 

Electronic market makers dark pools

Much like the broker-dealer owned dark pools, there is the chance for price discovery with electronic market maker dark pools. This is due to the fact these operators behave as principals for their own accounts. Examples of electronic market maker dark pools include: (3)Congressional Research Service."Dark Pools in Equity Trading: Policy Concerns and Recent Developments,"

• Getco
• Knight

Benefits of dark pools

At this point, it might not be wholly clear where the advantages lie with using dark pools. Well, there are a couple of interesting benefits to using dark pools that we want to touch on briefly. (4)National Association of Securities Dealers Automated Quotations."The Risk and Reward of More Dark Pool Trading."

Little to no market impacts

The primary reason that one would use a dark pool is due to the fact that large orders have a limited impact on the greater market. Block trading is frequently executed by institutional investors and at times, the size of the orders can have adverse effects on price movements of a security. The size of these orders create greater volatility in the market which can negatively affect the market in which an investor is trying to make a profit. 

For example, if a big company decides to sell 2 million of its shares on a public exchange, this could result in a major drop in stock price which in turn leads to greater volatility in the market itself. So, how does trading with dark pools help to combat this potential volatility? When trading with public exchanges, a larger company will not be able to hide the fact that they have parted with such a significant number of shares, as public exchanges are fully transparent. 

This is not the case when trading with dark pools, as dark pools are not accessible for the general public and do not reveal the identity of the selling company. That kind of information staying private can make a huge difference to the overall market reaction to the bulk sale of shares. 

No exchange fees and better pricing

Standard exchanges will charge fees for block trades which can amount to pretty significant fees over a long period of time. Dark pools do not charge exchange fees on executed trades which means that you cut out these costs. Orders crossed at the midpoint of the bid-ask spread will also greatly reduce the costs incurred from the spread itself. 

You can also regularly find better pricing for larger orders. These dark pools only generally have the bigger players involved which means that their orders can more favorably be matched by pool operators. Essentially, there is a better chance that the crossing orders at the midpoint will result in better bid ask prices for both the buyer and the seller in this equation. 

Limitations of dark pools

While there are certainly benefits to using dark pools, there are also some key limitations to its uses. It’s crucial that these limitations are understood before undertaking any larger block trades with any dark pools. 

Inaccurate pricing

When it comes to executing trades with over-the-counter public markets, there is always a risk that you are overpaying on a stock price. This is just the nature of the beast. However, the trades are transparent and you can see when larger institutions are dumping or purchasing stock which gives you some kind of opportunity to adjust accordingly. (5)National Association of Securities Dealers Automated Quotations.""The Risk and Reward of More Dark Pool Trading.""

If you are a retail investor, you are at an unfair disadvantage when using dark pools. If a number of larger institutions decide to dump stock well below the public market exchange price, retail investors are then at a disadvantage and can lose out greatly with their capital investments. As we can see here, the lack of transparency in dark pools is both a blessing and a curse, depending on where you find yourself within the market. 

Pinging risks

High frequency trading firms can execute a strategy that is known as pinging. The firms will execute small trading orders to get a feel for the dark pools market that help them to uncover if there are any larger block trades of a certain stock. Once they know for sure, they will then front-run the market (with their much larger capital resources for trading) at the expense of the smaller retail investors. (6)U.S. Securities and Exchange Commission."Shedding Light on Dark Pools."

Essentially, the high frequency trading firms will use the information they have acquired from their small trade executions, locate the larger block trades, acquire all the remaining shares in the market of a particular stock and then sell it back to these other intuitions that are looking to buy these shares. 

Dark pools FAQs

There are a number of questions that get asked daily about dark pools and how they work. We thought it would be a good idea to get some of the more pertinent questions in and answer them for you. 

Are dark pools actually legal?

Dark pools are very much legal. However, there have been instances in the past where larger firms have conducted unethical trades that essentially went against the interests of their own clients. The lack of transparency and regulation with dark pools have earned calls from key figures in finance to have these private exchanges be more closely regulated. 

How do dark pools affect stock markets?

In reality, dark pools can be quite beneficial as a whole for stock markets and their prices. When larger firms execute large-scale block trades on the public markets, they can impact the market value of stocks to a significant degree. The transparency that dark pools provide help to reduce price volatility in the market. This means that dark pools have far less impact on stock market movements than public exchanges. 

Is dark pool trading safe?

Dark pool trading is not inherently unsafe but as a smaller retail investor, there are a number of factors for you to consider. As we mentioned earlier, larger trading firms can execute pinging tactics which could impact the pricing of the shares you are trying to buy. While there may have been calls for more regulation of dark pools of late, there is still a chance that you fall prey to unethical trading practices that are essentially conflicts of interest with larger trading firms.