One of the top reasons why investors and traders use dark pools is to obtain better pricing by remaining private. Within a lit exchange, an institutional investor—such as a large pension fund—might try to sell thousands or millions of shares. This could quickly cause the price to drop before the transaction finalizes, as others could see that someone is trying to get rid of a lot of stock. Within a dark pool, however, the pension fund could try to sell all the shares they want to get rid of all at once (before the price can move against them). The fund could do this by matching with a buyer who agrees to the transaction price ahead of execution.
How Do Dark Pools Work?
Dark pools work by having broker-dealers or other parties, such as stock exchanges, set up private electronic venues to conduct trades. Within these private platforms, suppose a trader wants to buy a stock at $100 per share for its client, but the lowest publicly posted bid price on the NYSE is a few cents higher per share. Instead of having to buy the shares for $100.05, for example, the broker could submit the order via a dark pool, hoping the private system has a match with another party willing to sell at that $100 price. Those five cents might not seem like a big deal when trading a few shares, but the stakes change when dealing with institutional orders, which can encompass hundreds of thousands of shares. Small differences in pricing for both buying and selling securities can add up, especially when trading happens frequently.
Criticisms of Dark Pools
While dark pools are legal, they have come under regulatory scrutiny because of their lack of transparency. Sometimes ATS/dark pool operators have engaged in dishonest behavior—like front-running orders (tipping off other traders about a dark-pool trade)—that’s led to enforcement from the U.S. Securities and Exchange Commission. Ironically, dark pools were initially presented as a way to avoid front-running. This process occurs when a market participant, perhaps a high-frequency trader, takes the knowledge of an existing order that will move the market and then makes the same transaction first to obtain better pricing.
What Do Dark Pools Mean for Individual Investors?
Individuals generally can’t access dark pools directly on their own, just as you can’t walk onto the floor of the NYSE to buy and sell stocks—orders have to go through financial professionals like brokers. Still, if your broker ultimately places your order through a dark pool, that can affect your returns. So you may want to ask your broker about their trading procedures and how they can help you obtain the best pricing through either lit or dark pools. If you have a connection to an institutional investor—such as owning a pension fund or investing in mutual funds—dark pools can make an impact on you personally. A broker might be able to help these institutional investors obtain better pricing through a dark pool rather than paying the publicly listed price on a lit exchange. This can mean higher returns for these institutional funds, which can trickle down to the returns you see.
title: “What Is A Dark Pool " ShowToc: true date: “2022-12-09” author: “Christina Schey”
Institutional trading is global and can have a huge impact; the strategies and quantities of securities being traded can literally move their respective markets. To minimize this impact, institutional trading is often done in secret on legal, private, alternative trading systems (ATS), called “dark pools.” Below, we’ll dive into how dark pools work and if they impact your investment portfolio.
Definition and Examples of a Dark Pool
Dark pools are digital private markets where institutional investors such as pension funds, mutual funds, banks, corporations, sovereign wealth, hedge, and private equity funds trade.
Alternate name: Alternative Trading Systems (ATS), private trading networks, alternative trading networks
Dark pools offer very specific trading methods, but they broadly work in two ways:
They can match buyers and sellers at prevailing exchange prices (such as the midpoint between the bid/ask exchange price) They can operate as limit order books that execute trades based on price and time priority
In April 2021, dark pools executed about 13% of all U.S. equity trades, according to an analysis by institutional brokerage firm Rosenblatt Securities. “This protects fund orders, to a certain extent, from market participants that would seek to profit from knowledge of a fund’s trading intentions or strategies,” an Investment Company Institute (ICI) spokesperson told The Balance in an email. “Protecting confidential trading information reduces fund trading costs and provides greater returns to their investors.” On the flip side, since there is no disclosure about large volume trading in dark pools, the shares that trade on the open market don’t necessarily reflect the demand and supply of shares accurately.
How Were Dark Pools Created?
Dark pools began after the Securities and Exchange Commission (SEC) made a regulatory change in 1979. Traders wanted lower execution costs and did not want competitors to know what, when, the price, and quantity of instruments they were trading. As a result, dark pools were created so that prices were not publicly displayed. The first dark pool was created in 1986, with the launch of Instinet’s trading platform called After Hours Cross. It allowed investors to place anonymous orders that were matched after the markets closed. Just one year later, in 1987, a second platform emerged in the form of ITG’s POSIT. According to a 2015 Credit Suisse research note, the rise of dark pools can be attributed to three factors:
Regulatory changes Better trading technology A decline in market volatility
Regulation ATS created a framework to better integrate dark pools into the existing market system and to alleviate regulatory concerns surrounding them. In 2005, the SEC released Regulation NMS and opened the New York Stock Exchange (NYSE) to automated trading. Aside from these critical regulatory changes, advances in financial communications technology accelerated new hybrid strategies, such as flash and algorithmic trading that relied on speed, large order sizes, and liquidity to contain trading costs. All these were available in dark pools, but soon there were problems. The “flash crash” of 2010—an event that lasted about 36 minutes and wiped out almost $1 trillion in market value—showed that more regulation was needed to control high-frequency trading.
Purposes of Dark Pools and How They Work
The origins of dark pools are tied to five non-regulatory factors: The popularity of dark pools also stems from their specific trade execution formats and specialties. Almost all dark pools run as electronic limit order book markets. Some operate on a continuous trading basis throughout the day, while others are block trading-cross platforms. Some operate as non-displayed limit order books, while others execute orders at the exchange midpoint, and others that quickly accept or reject incoming orders. They also charge lower fees than traditional exchanges.
How Dark Pools Affect Individual Investors
While the dark pool market has expanded, it is still not clear how it impacts public stock exchanges where most individual and retail trades are conducted. With their growing popularity, regulators are concerned about issues related to market quality, price improvement, and market integrity. In 2018, the SEC adopted Rule 304 as an amendment to Regulation ATS to require the filing of Form ATS-N which includes a variety of disclosures about dark pools.
Dark Pools and Mutual Funds
Nearly 46% of American households owned mutual funds in 2020, a survey conducted by ICI found. And while dark pools are not something you as an individual investor may directly come in contact with, some mutual funds in your portfolio may deal with dark pools. According to Doron Narotzki, associate professor of accounting at the University of Akron in Ohio, some smaller mutual funds are using dark pools because they “need the trade volume to survive just like any other investment platform, and nowadays most dark pools will allow smaller investors to buy and sell through them. As a result, even smaller mutual funds can now use dark pools in order to make their orders and take advantage of what dark pools have to offer.” So where does this leave individual investors? Since 2014, the Financial Industry Regulatory Authority (FINRA) “has worked to improve market transparency and improve investor confidence by displaying activity levels in each ATS, including all dark pools,” Narotzki said in an email to The Balance. Under FINRA’s transparency initiative, details of total shares traded each quarter by security in each ATS or dark pool are displayed on its website free of charge. The Balance does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future performance. Investing involves risk, including the possible loss of principal. Concerns and Recent Developments (2014).” Concerns and Recent Developments (2014)." Concerns and Recent Developments (2014)." Concerns and Recent Developments (2014)." Concerns and Recent Developments (2014)." Concerns and Recent Developments (2014)." Concerns and Recent Developments (2014)." Concerns and Recent Developments (2014)." Concerns and Recent Developments (2014)." Concerns and Recent Developments (2014)." Concerns and Recent Developments (2014)." Concerns and Recent Developments (2014)." Concerns and Recent Developments (2014)." Concerns and Recent Developments (2014)." Concerns and Recent Developments (2014)." Concerns and Recent Developments (2014)." Accessed June 10, 2021.
