Dark Pool Explained

Dark pools are an ominous-sounding term for private exchanges or forums for securities trading. However, unlike stock exchanges, dark pools are not accessible by the investing public. Also known as “dark pools of liquidity,” these exchanges are so named for their complete lack of transparency. Dark pools came about primarily to facilitate block trading by institutional investors who did not wish to impact the markets with their large orders and obtain adverse prices for their trades.

Dark pools were cast in an unfavorable light in Michael Lewis’ bestseller Flash Boys: A Wall Street Revolt, but the reality is that they do serve a purpose. However, their lack of transparency makes them vulnerable to potential conflicts of interest by their owners and predatory trading practices by some high-frequency traders.

Why Use a Dark Pool?

Contrast this with the present-day situation, where an institutional investor uses a dark pool to sell a one million share block. The lack of transparency actually works in the institutional investor’s favour since it may result in a better-realized price than if the sale was executed on an exchange. Note that, as dark pool participants do not disclose their trading intention to the exchange before execution, there is no order book visible to the public. Trade execution details are only released to the consolidated tape after a delay.

The institutional seller has a better chance of finding a buyer for the full share block in a dark pool since it is a forum dedicated to large investors. The possibility of price improvement also exists if the mid-point of the quoted bid and ask price is used for the transaction. Of course, this assumes that there is no information leakage of the investor’s proposed sale and that the dark pool is not vulnerable to high-frequency trading (HFT) predators who could engage in front-running once they sense the investor’s trading intentions.

Types of Dark Pools

Broker-Dealer-Owned

These dark pools are set up by large broker-dealers for their clients and may also include their own proprietary traders. These dark pools derive their own prices from order flow, so there is an element of price discovery. Examples of such dark pools include Credit Suisse’s CrossFinder, Goldman Sachs’ Sigma X, Citi’s Citi Match and Citi Cross, and Morgan Stanley’s MS Pool.

Agency Broker or Exchange-Owned

These are dark pools that act as agents, not as principals. As prices are derived from exchanges — such as the midpoint of the National Best Bid and Offer (NBBO), there is no price discovery. Examples of agency broker dark pools include Instinet, Liquidnet and ITG Posit, while exchange-owned dark pools include those offered by BATS Trading and NYSE Euronext.

Electronic Market Makers

These are dark pools offered by independent operators like Getco and Knight, who operate as principals for their own account. Like the broker-dealer-owned dark pools, their transaction prices are not calculated from the NBBO, so there is price discovery.

Dark pools provide pricing and cost advantages to buy-side institutions such as mutual funds and pension funds, which hold that these benefits ultimately accrue to the retail investors who own these funds. However, dark pools’ lack of transparency makes them susceptible to conflicts of interest by their owners and predatory trading practices by HFT firms. HFT controversy has drawn increasing regulatory attention to dark pools, and implementation of the proposed “trade-at” rule could pose a threat to their long-term viability.