Dark Pool Trading
Dark pool trading involves legal private securities marketplaces that allow institutional investors to deal large blocks of shares, known as block trading, without revealing their secrets. While helpful to capital markets and retail investors, as dark pool trading volumes grow, they continue to face pressure from regulators who are uneasy about their opaque nature.
This guide explains what dark pool trading is, how it works and what investors may or may not find attractive about them.
What Is Dark Pool Trading?
Dark pool trading is an alternative investing system and equity trading venue.
It allows investors to place larger orders and trades without revealing their positions to the public or distorting the markets, providing additional liquidity and anonymity.
Dark pools can charge lower fees than exchanges as they are housed within a large firm, not a bank. Dark pool trading is done privately between the buyer and seller, often with the help of brokers.
As the name suggests, dark pool trading offers limited transparency. Dark pools are marketplaces where the price is only disclosed after a deal has been executed.
This was originally advantageous for big, institutional buyers and sellers who could execute large orders without making a significant price impact on the market. However, today many dark pools now let smaller-sized trades into their pools to create more liquidity.
An example of dark pool trading could be an institutional investor, such as Warren Buffet, buying shares in a company like Tesla. As a result of his influence, the stock price could jump significantly. In dark pools, this information would be concealed, preventing price volatility.
Dark pool trading is available in many jurisdictions including the US, Europe, Australia, Hong Kong, Japan, and Malaysia.
However, dark pool trading is not popular in India as rules ask for all trades to be reported on an exchange platform. Compared to the US, Canada has a higher level of transparency surrounding market trading volumes.
While there are pricing and cost advantages to buy-side institutions such as mutual funds and pension funds, these benefits ultimately accrue to the retail investors of the funds.
Internalization
A form of dark pool trading called ‘internalization’ has emerged where firms like Citigroup are taking business from stock exchanges by paying retail brokers for the opportunity to trade with their retail clients before those accounts go to an exchange to make a transaction.
Recent History
More recently, a growing percentage of blockchain-based trades are being executed in dark pools. Decentralized dark pool trading platforms are anonymized investing venues for large trades of cryptocurrencies, including Bitcoin.
Republic Protocol based in Singapore launched the first decentralized platform for dark pool trading in 2018.
Dark Pool Trading Vs Light Pool Trading
In traditional stock exchanges, when you send an order to the market with a price limit, that order shows up on the exchange’s public trading book. Traditional stock exchanges are sometimes referred to as ‘lit’ markets. Lit pool trading order books show prices and the amount of shares you want to trade. By making big orders, investors signal their intentions to others, causing a price change.
Dark pool trading has much less pre-trade transparency as it does not show how much investors want to buy or at what price. Dark pools were designed to increase competition and cut transaction costs.
With that said, dark pool trading needs traditional displayed markets to determine price benchmarks for stocks. As the price and amount of shares to be traded are hidden in dark pools, they look to displayed markets for price benchmarks.
Dark Pool Trading Vs Shadow Banking
The shadow banking system refers to various financial institutions such as hedge funds and investment banks which take on risks that traditional banks would not or could not take on as a result of tighter restrictions.
The lack of restrictions in shadow banking means that institutions can provide credit to those that would not usually receive access. There is also no investment insurance provided under a shadow banking system. Shadow banks often participate in areas that lack transparency, such as dark pool trading.
Dark Pool Trading & High Frequency Trading
Dark Pool Trading for Dummies explained that this type of investing was designed for big institutions but became more prevalent thanks to high frequency trading in the traditional displayed stock markets.
High frequency trading allows traders to execute their large orders ahead of other investors meaning they can capitalize on changes in share prices. Described as legal piracy by some, high frequency traders can earn huge and instantaneous profits when subsequent orders are made.
It became so widespread that executing large trades through a single exchange became difficult and orders had to be broken up into various exchanges. This tipped off competitors who could get in front and snatch up inventory, resulting in increased share price volatility.
To tackle the issue, dark pool trading provided institutions with a way to avoid predatory high frequency traders and their fast-paced algorithmic software and strategies which can identify large orders in the financial markets. However, the demand for more liquidity meant that some dark pools began letting high frequency traders in so that more trades could be matched.
Types Of Dark Pools
There are more than 50 dark pools registered with the Securities and Exchange Commission (SEC). There are three primary types of dark pools in the market.
- Broker or dealer-owned
- Exchange or agency-owned
- Electronic market makers
Broker-Dealer-Owned
Broker-dealer dark pools can be operated by financial services firms and investment banks. They buy and sell stocks for their clients and may include proprietary trading, investing for direct market gain rather than earning commission. These dark pools are known for offering price improvements and derive prices from their order flow so there is an element of price discovery, setting the spot price of assets, securities, commodities, futures, options or forex within their own market.
Examples of broker-dealer owned dark pools include:
- Barclays’s LX
- Citibank’s Citi-Match
- Goldman Sachs’ Sigma X
- Morgan Stanley’s MS Pool
- Credit Suisse’s CrossFinder
Exchange Or Agency-Owned
Independent exchange or agency-owned dark pools are provided by individual companies who must register with regulators such as the SEC and FINRA. They tend to provide liquidity to the market and offer low transaction costs. As prices are derived from exchanges, there is no price discovery.
These dark pools are mostly targeted by high frequency traders and form an important part of their automated trading strategies.
Examples of agency broker dark pools include:
- Instinet
- ITG Posit
- Liquidnet
SmartPool
Exchange-owned dark pools include those offered by NYSE Euronext, BATS Trading, and London Stock Exchange’s Turquoise.
Electronic Market Makers
These dark pools are offered by independent operators and there is price discovery.
Benefits Of Dark Pool Trading
Advantages of dark pool trading include:
- Private trading
- Lower transaction costs
- Avoidance of price devaluation
- Additional liquidity and anonymity
- Reduced market impact for large orders
Drawbacks Of Dark Pool Trading
The disadvantages of dark pool trading include:
- Lack of transparency
- Vulnerable to conflicts of interest
- Unfair advantages to high frequency traders
- Public values of certain securities are more unreliable and inaccurate
Impact Of Dark Pools On Retail Traders
Retail investors do not usually need to block trade shares in dark pools in the way that institutional investors do. However, pension funds and asset managers can get better prices for their end clients, retail investors, by trading in dark pools during market hours. This is the main benefit of dark pool trading to ordinary investors, even though they can’t access dark pools directly using charts and indicators.
Dark pool trading can also result in increased liquidity. Conversely, higher levels of off-exchange trading could reduce the liquidity found in traditional lit exchanges, culminating in higher transaction costs and less efficient markets for retail investors.
dark pools may bring several indirect advantages for retail investors, there is the potential for exploitation of users by more technologically advanced players.
By using dark pools, investors are more vulnerable to investment fraud and insider trading, unethical activity, and market manipulation. High frequency investors also use dark pool trading. They have computer algorithms to instantly move in and out of positions, earning significant gains from the profits on each trade.
Professional traders in dark pools have a competitive and information advantage over retail investors dealing on public exchanges. However, there is little evidence that dark pool trading leads to worse outcomes for retail investors.
Unless managing a substantial portfolio, retail traders are not going to drastically influence the market or other investors and will have little use for the anonymity that dark pool trading provides. Therefore, a retail investor typically has little use for dark pool trading despite its surge in popularity.
Regulations
As with all alternative trading systems, dark pools must be approved by the SEC if you’re in the US. Dark pool trading is not illegal but is tightly regulated by the SEC because of its lack of transparency around how it works and definitions. As dark pool trading has grown in popularity, regulators have taken more interest in how dark pools are run.
Europe’s Mifid II regulation was supposed to pull share trading on public exchanges from dark pools. However, its introduction saw trading volumes increase exponentially after the European Securities and Markets Authority admitted it did not have the data to apply its proposed caps on dark pool trading.
MiFID II banned trading on a set of venues with no pre-trade transparency and trades on regulated markets could only occur in volume or block trades. However, the UK regulator, the Financial Conduct Authority (FCA), lifted the ban in December 2020, announcing investors could trade without restriction in dark pools.
The SEC proposed a pilot “trade-at” rule to help traditional exchanges reclaim market share from dark pools and other off-exchange venues. The rule would require brokerages to send client trades to exchanges rather than dark pools unless they can execute the trades at a meaningfully better price than that available in the public market. The new rule could cause problems to the long-term viability of dark pool trading if implemented.
In December 2020, dark pools owned by major Wall Street brokers made tens of thousands of trades in the shares of GameStop, a NYSE-listed company, coinciding with a spike of 1,147% in its share price. Dark pool trading volume in GameStop went from 4.9m shares to 44.1m in a week – an increase of 800%. This raised questions about the integrity of US market activity.
How To Trade Dark Pools
Finding a financial advisor could help when considering dark pool trading and evaluating the various investment types such as stocks, bonds, or mutual funds.
Some dark pools are operated by exchanges as a private way to trade with some of the structures of lit public stock exchange trading. Many big investment banks, such as UBS, Credit Suisse, Barclays, Goldman Sachs, and JPMorgan Chase, also operate dark pools.
Online guidance on forums such as Reddit and Twitter accounts like MRC Dark Pool Trading are good places to go to look for discussions around dark pool trading brokers and strategies. There is a dark pool app by The Stock Whisperer that also offers strategy tips. Additionally, Ben Sturgill, author at Raging Bull, a trading platform to exchange tips and secrets, has built a dark pool scanner to monitor and flag large and unusual block trades.
Final Word
Dark pool trading is an alternative trading system that is offered by independent companies, broker-dealers, and investment companies. They primarily help institutional investors and small market participants get involved in the market anonymously and trade information is only revealed after the order is placed. While the level of anonymity is appealing, the lack of visibility and certainty in dark pool trading can increase the level of risk.
FAQ
What's Dark Pool Trading?
Dark pool trading was created to allow larger block trading by institutional investors without revealing their positions to the public or distorting the markets. Dark pools are marketplaces where the price is only disclosed after a deal has been executed and therefore reduces market volatility.
Is Dark Pool Trading Legal?
Yes, dark pool trading is legal and is tightly regulated. However, the nature of dark pools is that order book information is hidden. This lack of transparency gives the form of investing its name.
How Does Dark Pool Trading Work?
Principally, dark pool trading exists for large-scale investors that don’t want to influence the market through their trades. When other investors see influential investors’ trades and follow them, it can cause stock prices to rise. Dark pool trading prevents price swings by hiding order information.
How Do I Access Dark Pool Trading?
There are three primary types of dark pools in the market: broker or dealer-owned, operated by companies such as financial services firms and investment banks which buy/sell stocks for their clients (retail investors), exchange or agency-owned companies, and electronic market makers who are independent operators.
How To Spot Dark Pool Trading?
You can see traces of dark pool trading transactions on the public markets by monitoring the internet as finance journalists regularly report on big trades. You can also set up alerts on Google or follow Twitter accounts such as MCR Dark Pool Trading who reports on the hot trades of the week.