What are Dark Pools?

Liquidity is probably the most important part of trading. The more serious traders spend a lot of time trying to understand market microstructure, something about which we have written recently.

The larger you are (or the more illiquid the market), the more important it is to smartly execute your orders without severely impacting the market price, and thus pushing your position against yourself.

This is one of the reasons that led to the invention of dark pools (also known as dark liquidity), which are private networks for executing trades. Using dark pools, large institutional traders and investors can buy and sell large chunks of assets without screaming to the world that they are getting in or out of the market, which could lead to attempted front-running. 

A dark pool is similar to any other exchange, the only difference being that the liquidity is ‘dark’ and not visible to any other market participants. Most of the transactions in dark pools are executed by institutional trades and investors, who often engage in large block trades.

These dark pools:

• Act as alternative trading systems (known as ATS)
• Are available to large institutional investors 
• Allow for private and anonymous transactions

Dark pools are completely legal and are regulated by the S.E.C (Securities and Exchange Commission). However, they have been under more scrutiny due to their lack of transparency, and some are thought to have conflicts of interest with HFTs and some of their more shady trading practices.

There are several different types of dark pools, which include: 

• Broker-Dealer Dark Pools: These dark pools are set up for broker-dealers clients and often include their own prop traders. These dark pools device their own prices from the internal order flow, therefore experiencing an element of price discovery.

Some common examples of such dark pools are:

• MS Pool (Morgan Stanley)
• LX Liquidity Cross (Barclays Capital)
• Sigma X (Goldman Sachs)
• BIX (BNP Paribas)
• Citadel Connect (Citadel)

• Agency Broker Dark Pools: These dark pools act as agents rather than principles, and their prices are derived from exchanges such as NBBO (National Best Bid and Offer). Due to the absence of a price discovery mechanism, they do not perform principal functions.

Some familiar agency broker dark pools are:

• Liquidnet
• ITG Posit
• BATS Trading
• NYSE Euronext 

• Electronic Market Maker Dark Pools: These dark pools are managed and run by independent securities operators, who act as principals for their accounts. This setup means there is price discovery.

Getco and Knight are an example of an independent dark pool operator.

Dark pools are becoming more and more popular with traders. This is primarily because of the following factors:

• Limited Market Impact: This is probably the most significant advantage of trading in dark pools. The risk of inadvertently moving the market against their position is reduced, since orders are matched in a manner similar to OTC (over-the-counter) trades, whereby similar sized participants trade with each other, rather than a single order just going into the market and taking all available liquidity at the next best price.

• Privacy: Since trades are anonymous (at least until they are completed), the rest of the market remains unaware of the intentions of those buying or selling the asset in question, which means large trades are revealed to the rest of the market only after they have been executed. Since market sentiment can play a massive role in influencing market prices, executing trades out of the market spotlight can reduce the risk of under and over-reaction. 

Despite being enjoying some unique advantages as compared to traditional exchanges, dark pools are still subject to some disadvantages, such as:

• Price Discrepancy: Dark pools do not reveal any details about liquidity until after a trade has taken place. When stock markets were in their electronic infancy, it was possible to see who was posting liquidity. For example, you would have been able to see that the 10 million shares sitting in the book were on offer from Goldman Sachs. Nowadays, and with the advent of dark pools, the origin of such large orders are unknown.

This impacts the price discovery process on the traditional stock exchanges (also           known as lit pools), since the prices there do not account for such material                     pieces of information about liquidity.

• Lack of Transparency: The dark pools lack transparency as they allow large investors to place orders for block trades without revealing their intention to the general public. Arguably, this hides conflicts of interest and puts traders on the lit markets at a disadvantage.

A dark pool offers an excellent platform for executing block trades with maximum privacy, especially for large institutional investors. These secretive exchanges allow their traders to fulfil their orders at favourable prices and with access to ample liquidity. 

However, dark pools are often criticized because of their lack of transparency. It is also thought to impact the price discovery process of the broader market and may potentially put participants using traditional exchanges at a disadvantage.

While dark pools contain ‘invisible’ orders, Bookmap is all about seeing the unseen, and the after effects from dark pools can sometimes be seen on our heatmap. You can try it out today for free. Click here to get started.