A dark pool is an alternative trading system that offers large institutional investors private trading platforms. The primary motive behind these off-exchange platforms was to facilitate block trades. The advent of electronic trading has facilitated high-frequency trades as well. Dark Pools come with a negative perception, largely due to their lack of transparency.
What are Dark Pools?
A dark pool is a private financial exchange or a trading platform for trading securities. It represents a form of an alternative trading system (ATS) that offers trading services to large and institutional investors usually.
One of the key features of dark pools is that trades executed are not made public until the transactions are completed. Considering several other reasons too, these alternative trading systems do not face a higher degree of regulations than conventional exchanges. Off-exchange trading has significantly increased in the past few years. A report suggests that non-exchange trading accounts for nearly 40% of the total volume in the US alone. Therefore dark pools are responsible for a considerable amount of all of the trading done in US markets.
The Emergence of Dark Pools
These alternative trading systems are mainly offered services to large institutional investors. Institutional investors trade a large number of stocks through a single large trade order. With tight SEC regulations, commission, interest charges, and repercussions, these transactions wouldn’t seem possible through traditional exchanges.
The emergence of electronic trading means private exchanges can be set up purely in digital form. Private and large investors can use these platforms to execute such large-scale transactions. Hedge funds, mutual funds, and pension funds are typical investors of large trades that involve a huge number of stocks. For those reasons, they are among the most common users of dark pools.
There are two main drivers behind the emergence of dark pools:
Without any set rules, a block trade is a type of trading activity that involves a large number of securities in single trade order. Block trades were the primary motive behind the emergence of dark pools. A large trade transaction through financial exchanges would certainly result in the devaluation of the underlying security due to the signaling effect. For this reason, dark pools are the best way to conduct block trades.
High-Frequency Trading (HFTs)
The emergence of electronic trading has resulted in high-frequency trades in recent years. It means the dark pool platforms are no longer used for block trades only. High-frequency trading also uses dark pools extensively. Because trading platforms can divide a single large trade order into several small orders. They also operate in different exchanges simultaneously.
Types of Dark Pool
Dark pool facilitates large investors to execute trade orders privately, and efficiently. There are three main categories of dark pools, that are used depending on the specific purpose of the investor behind each trade.
These off-exchange trading platforms are run by large broker-dealers to facilitate institutional clients. These platforms serve their investors through direct placements of orders. The platforms derive their prices privately. Morgan Stanley’s MS, Goldman Sachs’s Six Sigma, and Citi-Match are a few prominent broker-dealer-owned dark pools.
Akin to traditional financial exchanges, these dark pools act as agencies or agents of their clients. Since prices with these types of off-exchange platforms are not set privately, there is no element of price discovery here. Some of the prominent agency brokers include Liquidnet, Instinet, and ITG Posit. Exchange-owned dark pools include Euronext, BATS trading, etc.
Electronic Market Makers
These dark pool trading platforms act as principals of their accounts. The order prices are derived and calculated privately like broker-dealer platforms. Electronic market makers are privately run platforms, for example, Knight and Getco.
Advantages and Disadvantages of Dark Pools
Dark pools largely come with a negative impression due to their lack of transparency. However, they offer some benefits as well as some disadvantages.
Increased Market Efficiency and Liquidity
Dark pools facilitate high-frequency trading, resulting in improved liquidity and market efficiency. These platforms make it possible to execute large transactions through high-frequency trading that could take a delayed time through traditional exchanges.
Controlled Market Impact
Most dark pool transactions do not reveal trade prices to the public. Also, the large transactions are broken into a large number of transactions that help control the price fluctuation of the underlying security.
Perhaps the most beneficial feature of dark pools by institutional investors is private trading through these platforms. Unlike conventional exchanges, off-exchange trades do not result in overreaction or underreaction by the market. This allows these large institutions to trade securities without directly affecting the price due to the large volume of the trade.
Lack of Transparency
Private trading and a lack of regulatory repercussions mean dark pools come with a lack of transparency. That leads to several questionable practices such as a conflict of interest, unethical investing, and avoiding trading costs. Dark pools continued to be viewed negatively by some market participants, like retail investors.
Dark pools can privately handle large transactions. It means influential investors can manipulate trading that may put other investors at a disadvantage. The fact that these transactions are conducted privately, leads some market participants to wonder what really goes on behind dark pools.
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