All About Dark Pools

9 min read

By Chainika Thakar

This article takes you from the meaning of Dark Pools, all through its exciting history and present situation. If you wish to explore the topic or be aware of trading in Dark Pools, this article will give you a good insight into the same.

Let us move ahead and find out more about the Dark Pools in this article, as it covers:

What is a Dark Pool in Trading?

“Dark Pools” is a very creative name given to private stock markets housed in some large institutions like banks. They are legal private securities marketplaces and are also known as Alternative Trading Systems (ATS).

Basically, these are an alternative to trading on the stock exchanges like the New York Stock Exchange and Dow Jones. Hence, these are called over-the-counter trading practices. Moreover, the traders investing through Dark Pools remain quite ahead of the other traders in the marketplaces. Over the years, it is believed that shares are traded more in Dark Pools than on stock exchanges.

The actual purpose of the Dark Pool in trading is to give the investors/traders an ability to get their orders filled according to the National Best Bid and Offer (NBBO). NBBO is a regulation by the United States Securities Exchange Commission (SEC). This regulation provides the traders with the best (high) bid price (in case of selling securities and with the best (low) offer price (in case of buying securities).

Getting their orders filled according to NBBO is particularly important for the institutional traders who invest large chunks of funds in trading.

Although this type of trading brings down the trading cost, its effect (positive or negative) on the markets (because of the entire information being “private”) is yet to be understood.

For instance, if an investment bank buys shares worth a million dollars of a company to diversify its portfolio, it is bound to make an impact on the market price of the company. Whereas, if it trades privately there will not be any volatility or affect in the marketplace.

Gradually, the dark pools got regulated by U.S authorities. The regulation was a slow process as they made their first appearance in 1979 or early 1980s but the SEC did not regulate them until 1998.

To gather more knowledge on Dark Pools, let us find out about the History of Dark Pools ahead. We will discuss when the Dark Pools came into existence and their progress over the years.

Let us go ahead and look back at Why do Dark Pools Exist?

A Brief History: Why do Dark Pools Exist?

Dark Pools came into existence because of the institutional investors wanting to go about their investing privately without the involvement of exchanges. This was so since dark pools give the opportunity to trade without risking their investment with potential adverse price movements in the markets. Moreover, all the trades remain anonymous until and unless some legal requirements need the traders to share any details.

This was a brief about how they came into being, we will now discuss the History of Dark Pools starting from the beginning, which is like this:

  • The origin of Dark Pools dates back to 1979 when it all started. After the 26th April 1979, any security listed on a given exchange was allowed to be traded privately.
  • In the 1980s, they picked pace and several investors began investing in dark pools. In the beginning, dark pools trading was known as “upstairs trading”. There was a portion of investors trading in the dark pools out of the total trading activity.
  • In 1986, Dark Pools became even more popular and the investors entered orders during the day. By the end of the day at 6:30 Eastern Standard Time, an algorithm for the trading would get the buyers and sellers matched based on the closing price of the security. This would mean settlement for the traders.
  • By 1998, SEC regulated Dark Pools which remained unregulated before that.
  • In 2017, according to Bloomberg, it was observed that 40% of all the executed trades were done in dark pools in the U.S.

After exploring the history of Dark Pools, briefly, let us find out what is the Present Situation of Dark Pools.

Present Situation of Dark Pools

Presently, Dark Pools have become more prevalent than ever before. Dark Pools began because of the need of the big institutional investors or traders. Over the years, it became a great way to take care of one’s funds or investments. Especially the brokers and banks are utilising them by matching the orders of their clients in their own dark pools.

It is important to note here that Dark Pools are operational as a profitable business for not only investors but also for the middle entities. These entities are making their clientele optimistic enough about using their dark pools since with the same, they can trade without any fees to be paid to the stock exchange.

Althemore, the entities also can trade themselves (buy and sell securities) so as to profit more with the trading. Hence, the Dark Pools are now spread across the globe.

Now, in February 2018, according to Wall Street On Parade, when Dow plunged 1000 points, various banks like JP Morgan traded in their own stocks. Adding the two Dark Pool trades of JP Morgan, it was 2,521 times that JP Morgan invested in its own stocks in a single week.

Also, according to SmartAsset, in April 2019, the share of U.S. stock trades executed on dark pools and other off-market vehicles was almost 39%, according to a Wall Street Journal report.

In today’s time, Dark Pools are more prevalent and, in the United States, dark pools have become an integral part of the marketplace. Hence, it seems that there is no escape from the Dark Pools and they are the most common in the U.S than any other country.

Moving ahead, there is a List or Types of Dark Pools we will take a look at.

List or Types of Dark Pools

Dark Pools are mainly of three types, which are:

  • Independent
  • Broker-Dealer Based
  • Exchange Based

Independent

These dark pool providers, as the name suggests, are operated by independent or single firms. These providers provide the clientele with low transaction charges and also bring down the costs that occur due to less liquidity. For instance, the independent providers in the U.S are Instinet and ITG.

Broker-Dealer Based

These providers are basically the investment banks which offer their clientele with price improvement with the help of NBBO. Also, these providers are specialists in trade relating to other banks or the participants on the “buy-side”. For instance, Broker-Dealer providers are JPMorgan Chase and Barclays Capital.

Exchange Based

Exchange-based providers give access to retail traders who are interested in over-the-counter or off-the exchange trading. These usually provide an increased level of liquidity to the participants in the market. For instance, these providers are NYSE Euronext and the International Securities Exchange (ISE).

Heading to the next section, we will learn about some Interesting Facts relating to the Dark Pools trading.

Interesting Facts

Dark Pools is itself quite an interesting concept. It gets the participants a different experience as the trades in Dark Pools are not done through the exchange. There are several aspects of Dark Pools, which are quite interesting to explore. Let us take a look at them one by one.

With Dark Pools, you may not be sure of prices

This is factual that you may not be sure of prices with Dark Pools since there is a possibility that you may end up paying too much or too little. Nevertheless, this can be taken care of by keeping a close watch on the data available in the market. This way, you can tally the prices you are offered to trade with. However, the traders investing in a dark pool, trade quite in advance of the market. This makes the stocks you purchase or sell today to change in price sometime soon.

Dark Pools are not considered transparent

Dark Pools, as their name suggests, are dark and not visible. Conversely, when you trade through a stock exchange and send an order to be executed, the order shows in the exchange’s trading book. This order (price and amount of shares you wish to trade) becomes available for the public eye.

Dark Pools have spread across the world

Dark Pools, now, exist all over the globe and a huge part of the total trading happens in the dark or privately. In the U.S, as we mentioned above, almost half of the total shares are traded in a dark pool. Also, they are the most common in the U.S as the marketplaces in the United States are mostly about equity trading and they are to be more common in any country with growing equity trading.

Dark Pools and Stock markets

In the Dark Pools, traders usually operate on the basis of average prices of the best bid (buy price) and the best offer (sell price) in the stock markets. Here, the best bid is the highest price a buyer readily agrees to pay and the best offer is the lowest price a seller readily agrees to sell its stock at. The traders take an average price out of the market’s best bid and best offer prices, and this way the dark pool helps them receive a better price than the market prices.

HFT helped Dark Pools grow

It is important to note that HFT or High-frequency-trading has helped dark pools grow to the extent of several trades happening through it. High-frequency trading practice implies the highest speed at which trading takes place. Since it allows a huge number of trades to take place in the shortest time possible, more of the traders wish to take advantage of large orders privately.

Dark Pools are not illegal

This private trading is a legal practice and also is regulated by the authorities in the U.S. Ever since the Dark Pools started growing, the regulators have kept a close watch on the same. The national financial authorities in the countries with Dark Pool trading have been monitoring and policing their every aspect of the conducting business.

You can read about the regulations in the research paper here.

Aforementioned were some of the interesting facts about Dark Pools. Discussing them aimed at enhancing your knowledge with regard to private trading. This type of trading has its own advantages and disadvantages, which we will now discuss ahead in the section “Pros & Cons of Dark Pools”.

Pros & Cons of Dark Pools

Dark Pools exist, undoubtedly, because of several advantages that it offers to the traders who buy and sell the securities through this channel. But, it is not that all the things are rosy. There are Pros of investing privately, but it surely has some disadvantages or Cons as well.

Being aware of them both helps one be safe from the losses or adverse effects that this type of investing may lead to.

Okay, let us now discuss both the sides of trading in Dark Pools.

Pros

  • One of the main advantages of Dark Pools is that the traders or investors enjoy an upper hand when it comes to executing the trade. It is so because the trades executed through the private channel are ahead of the marketplace or the ones done on the exchange.
  • With the Dark Pools, you also get the advantage of the pricing data remaining private. This implies that in case of private trading, since the data is not visible to the public, unlike exchange-based trading, a sudden spike in volume does not take place. This prevents the volatility and thus, the trader’s order either gets filled at the price or not.
  • The traders remaining anonymous in the Dark Pools trading helps them since the competing investors or traders can not strategise against them. In this case, since pending market orders are not visible to other traders, they can not plan anything against the private traders to extract the benefits out of the trading ahead of them.

Cons

  • Ever since the Dark Pools came into being, there has been a debate about their impact on the exchange-based trading practices. It is believed that such trading practices lead to an adverse effect on the exchange-based trading by making the trading in this domain be competed with.
  • Another point is that private trading is leading to draining of liquidity from the firms involved in exchange-based trading practices. Since the Dark Pools are growing constantly, more and more traders are engaging in private trading.
  • Also, with the low liquidity, another problem that arises is of the bid-ask spread. It grows inevitably and leads to higher transaction costs for market participants on the exchange. Consequently, it leads to decreased market efficiency.
  • The most common disadvantage of private trading is the potential for fraud in trading activities since all the details remain hidden. Since there is a lack of transparency, there have been cases of unethical use of High-frequency trading. As we discussed HFT above, a trader can take unethical advantage of HFT in private trading. This creates an “uneven” trading field.

Alright! We have reached the end of the article and have gone through quite a few important aspects of trading in Dark Pools. Let us see what all we covered.

Conclusion

In this article, we discussed the basic aspects of Dark Pools and covered some important facts about the same. There are many discussions and confusions relating to the advantages it brings to the traders and whether or not the investments are safe. Hence, we discussed all that in brief so as to make the aspects that revolve around it more clear. While some of our readers find history and a clear definition of the topic appealing, others wish to delve deeper into the same. This article covered the related topics around Dark Pools with a brief overview of investing in Dark Pools.

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