Take a dip in the Dark Pool

Dark Pools. You may have heard of them, you may not have, but they’re important to the market because as of February 2016, more shares were traded on them than on the NYSE. So, what are they? How do they work? And why do they matter? These are all questions we’re going to answer here today. Dark pools are another name for a type of alternative trading system. For reference, a typical trading system is any system that allows for consistent and reliable trading, the NYSE is an example. To get an understanding for the size of the market, there are about 11 public exchanges, and about 45 alternative trading systems. What are the differences? Unlike a typical stock exchange, dark pools don’t reveal the size of orders or the price that orders are filled at until the orders have already been executed. The purpose of a dark pool is mostly to trade large blocks of shares without other traders knowing. They came about in the 1960’s, and by the 1980’s they were really growing in popularity. Previously, trading in a dark pool was just called “Upstairs Trading” and it was really reserved for sophisticated players like banks and hedge funds.

Dark Pools are mostly operated by brokerages, which sometimes calls their legitimacy into question. In 2008 about 16% of all trading occurred on dark pools until that number more than doubled to 40% in 2014, and as I mentioned before more than 50% of all trades occur on dark pools. Much of this rise can be attributed to high-frequency traders trading against large institutions that must move large blocks of shares. HFTs really became a market competitor around 2008 as technology and software became advanced enough to work with. Brokerages decided to combat the problem by trading more on dark pools. Some brokerages may be taking advantage of this system as they have access to privileged information because they run the thing. If you run a dark pool and you know where the trades are going, you may be able to “spoof” the trades and make a little profit on top of any trades that you see coming in. As a response to broker dealers acting unethically and hedge funds trying to trade against banks within dark pools, nine of the largest asset managers have created their own dark pools specifically for institutional investors.

Dark pools do offer a lot of advantages though. Often times dark pools have attractive fee structures because they are run by a small unit of a larger business that takes care of overhead costs. This means that usually there is no spread when trading on a dark pool. Dark pools are still mandated to offer the NBBO, (National Best Bid and Offer) but since there is no spread to collect, the price of securities is usually the midpoint of the NBBO. Bloomberg LP maintains their own dark pool called Tradebook, so it’s not a market exclusively for brokerages. ATS execution is often quicker as well. There are so many dark pools out there and they all have differentiated features so some institutions are more likely to use certain ones depending on what type they are. For instance, there are dark pools for buy side institutions that only trade with each other.

Since the brokerages that maintain dark pools are registered with the SEC and FINRA, there is some level of expectation that these ATSs are regulated. Users of these pools are generally sophisticated investors who know what to watch out for when they’re trading on them. The alternative, trading on a typical exchange, is pretty grim for firms that are trying to trade large blocks of shares on the other exchanges. It’s easy to spot when the institutions trade in the regular markets. Usually retirement accounts or large institutional funds move money around 10am to 2pm and you can usually see steady volume for different shares as the institutions break up the number of shares they are trying to trade and purchase or sell in the public exchanges. Dark pools make it much easier for banks to get good prices as well without alerting their competition to what they’re doing.

Countries such as Canada and Australia are putting legislation in place to limit dark pool trading, and the European Union is considering rules for the practice as well. This is in response to the lack of transparency surrounding the trading systems. As I mentioned before, since brokerages usually run them, there can be conflicts of interest in information dissemination. In January of last year, Barclays and Credit Suisse settled a case with the SEC and office of the New York Attorney General for $154.3 million over misleading customers about handling dark pool orders. One thing is clear though; dark pools are growing in popularity and probably aren’t going away anytime soon.


Sources:

Luis A. Aguilar, S. C. (2015, November 18). Shedding Light on Dark Pools. Retrieved from U.S. Securities and Exchange Commission : https://www.sec.gov/news/statement/shedding-light-on-dark-pools.html

Mamudi, S. (2016, February 1). Dark Pools; Private Stock Trading vs. Public Exchanges . Retrieved from Bloomberg.com: https://www.bloomberg.com/quicktake/dark-pools

Picardo, E. (2017). An Introduction to Dark Pools. Retrieved from Investopedia : http://www.investopedia.com/articles/markets/050614/introduction-dark-pools.asp

Ross, D. K. (2013, February 2). 10 Things People Don’t Get About Dark Pools. Retrieved from CNBC: http://www.cnbc.com/id/100424690

 

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