Dark Pools are a mystery for most people, they don't know how dark pools function, hence there are many misconceptions about dark pools. Dark Pools are very similar to stock exchanges, where trading is done on Alternative Trading Systems. The major difference is that the detail of an order placed at dark pool is invisible, therefore order size and bid prize are not exposed to other traders.
There is a lot of criticism about dark pools from non-users, though the actual dark pool traders are happy with the system. Here we try to shed some light on dark pools.
- Dark pools provide us the option to execute large orders with minimal impact cost
Dark Pools are a type of market place where identity of buyers and sellers are not known to each other. The traders bid their orders with a hope to get their orders filled. Before the existence of dark pools, if you wish to buy a large quantity of a stock, all the options such as VWAP or slow trade over next few days were predictable, risky and would result in market impact.
- Dark pools have problems like gaming strategies, front running, pinging, which makes them hard and challenging to use
Having said that, the reality of Dark Pools is more complicated. There are many ways in which gamers engage in strategies that infer the existence of order in Dark Pool such as quote manipulation, pinging, front running, price moving, etc. For instance, a buyer might bid for buying a small quantity of say 100 stocks. If it gets filled quickly, he knows that there is a seller in the market with a ‘big’ order. This way dark pool which seems to be anonymous or ‘dark’ doesn’t really remain so.
- Dark pools employ various methods to avoid information leakage
Limited participation in dark pools and enforcing minimum quantity for trading are a few ways to avoid gaming and information leakage. However, different pools behave in different ways.
- There are more than 30 different dark pools in the US market
They all operate independently from each other and there is no transparency or formal consolidation between them.
- The retail players are against dark pools
Dark pools might affect the market adversely or not at all. If a large trade happens in a dark pool, which got later communicated to the market, the market might react in a sudden rise or collapse. This might not affect the trading parties but might affect the rest of the players who were not involved in the initial trade. The retail players are against dark pools since they are not allowed to trade in dark pools and hence can’t benefit from this market place