Dark pools are exchanges that keep certain order data private. Here’s what that means for investors.
Judging by its name, dark pools seem to be equal parts alluring and controversial — which is exactly how many people would describe them.
Regulation for dark pools is more limited than traditional stock exchanges. Much like the rebellious childhood friend whose parents were never around, this could either mean an exciting amount of freedom or a dangerous amount of vulnerability, depending on your perspective.
Not every dark pool is the same, especially since each one may have different operational rules. Still, as popularity in dark pools grows, understanding how they work may help traders decide if dark pools fit into their investing strategy.
SPOTLIGHT ON DARK POOLS
A dark pool is a private securities exchange where investors can buy and sell orders without disclosing certain order data to the public. Unlike traditional stock exchanges, this type of Alternative Trading System (ATS) allows investors to trade without publishing information about the price or the number of shares. Since there is no publicly available order book, the exchange keeps the trade in the “dark,” so to speak.
This type of trading dates back to the 1980s, when the U.S. Securities and Exchange Commission (SEC) passed regulation that allowed investors to trade in a different exchange from where it was listed. Historically, traders would place their trades at a broker-dealer’s desk above the trading floor, leading some to call this “upstairs trading.” As trading technology evolved, the number of electronic dark pools increased.
INVESTORS IN THE DEEP END
Initially, those who traded in dark pools were primarily large institutions and hedge funds. If the institutional traders wanted to buy or sell a significant number of shares in a traditional exchange, the market might react against them.
For example, if an investor wanted to sell 500,000 shares in a traditional stock exchange, he might need to sell in parcels over a series of smaller trades. As other traders learn about this, the price of the shares could drop. Within the privacy of a dark pool, buyers and sellers are more likely to complete a large trade without triggering a market reaction.
But dark pools aren’t limited to institutions. To attract more buy and sell orders, many dark pools allow smaller trades into their pools to create more liquidity. In fact, the average trade size seems to be decreasing to fewer than 200 shares, according to data from the Financial Industry Regulatory Authority (FINRA). This could suggest the majority of trades in dark pools are not necessarily large ones by institutional investors.
SINK OR SWIM
One major advantage of dark pools for institutional investors is the chance to limit the market impact for orders. Moreover, institutional sellers have a better chance of finding buyers for the full size of the share, since traders expect to see large investors at dark pools.
Dark pools may also have a chance to lower transaction costs, since dark pools do not have to pay traditional exchange fees.
Though the costs of the transaction could potentially be lower, there is no guarantee that the trade will have the best price. The lack of transparency in dark pools means the price of shares may not accurately reflect market supply and demand.
Another disadvantage of dark pools is the potential for them to leave retail traders more vulnerable. Without regulatory oversight, dark pool owners might engage in conflicts of interest if the broker-dealer’s proprietary traders trade against pool clients, or if the broker-dealer sells special access to high-frequency trading firms.
Since dark pools are not required to publish how their trading platforms work the way that traditional exchanges do, the dark pools may be more susceptible to exploitation from owners, traders with faster trading technology, or both.
LIFEGUARD OFF DUTY
By nature, dark pools evolved with limited regulatory oversight. However, many critics have advocated for more regulatory initiatives, citing the lack of transparency and inconsistent rules among dark pools.
Since 2016, FINRA has made weekly ATS trading data available online to enhance market transparency. Traders can view aggregated ATS data on a stock-by-stock basis as well as the total shares, total trades, and average trade size per ATS.
In 2018, the U.S. SEC began requiring every ATS to file a form that discloses operations within the ATS as well as ATS-related activities of the broker-dealer operator. These disclosures include potential conflicts of interest, methods, and fees.
Some critics argue this regulation is not thorough enough; others prefer the advantages that come with limited regulatory standards. Whichever way regulation may develop for them, dark pools involve their own risks.
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