When discussing different forms of investment, one of the most available types to the public is the stock exchange. Pew Research Center estimates that 52% of American households have some form of investment in the stock market. Most of this investment is usually in the form of retirement accounts and 401(k)s.
Although stock markets thrive on transparency, not all the information is available to the public. One such example are Dark pools, but what exactly are they? This article answers all your questions and more.
What are Dark Pools?
Dark pools are private forums where institutions are allowed to trade large amounts of stock. This is done in total secrecy without the investing public finding out. Dark pools first started in the 1980’s after the U.S Securities and Exchange Commission’s (SEC) new regulations to allow block trading.
Block trades are high-volume transactions that are privately negotiated and are executed outside the open market.
For a trade to be considered for dark pools, it must meet certain quantity thresholds. The minimum block size requirements are outlined under ICE Swap Trade Rulebook. Given the large volumes of contracts, block traders often negotiate for better prices — only large financial institutions like hedge funds, insurance providers, and pension funds.
Why Do Dark Pools Exist?
Although dark pools get a lot of bad press, they serve a good purpose. By hiding the details of such a high-volume transaction, the market is not disrupted. A block trade executed in public can easily cause panic. In general, a block trade visible to the public may have an investor interpret it as a desperation sell or buy of a particular stock. Other investors may attempt to execute a similar order resulting in a swell in supply. The result is that the stocks may devalue.
Dark pools also increase the likelihood of selling a large block of securities without breaking into smaller units. A one-time sale is easier to negotiate and execute than several separate trades. Although dark pools were made for big institutions, banks and brokers have opened up these forums to retail investors. It helps them avoid stock exchange fees hence a higher profit margin.
Whatever your feelings are for the dark pools, they are here to stay. The part of the market structure adds to the efficiency of the stock market by providing liquidity of certain securities. Dark pools have become so prevalent that almost 40% of all executed stock trades in the U.S are done in dark pools.
How are Dark Pools Used?
Most times, the buyer and the seller trade directly in a dark pool with the help of a broker. Like traditional stock markets, dark pools have pricing rules and the same order types. The only difference is that the trades are off-market or over the counter.
There are about 40 dark pools in America run by different brokerage firms. The first step is to join a dark pool.
They are perfectly legal, and you can approach any bank or broker. You will stake the number of shares you are planning to dispose of. It could have millions or even billions worth of shares. The broker will match you with a buyer willing to acquire the entire portfolio or at least most of it. The order is executed anonymously to prevent alerting the public.
However, the trade has to be disclosed to the public once the order is executed. The rationale is that it can’t impact the market once the sale is complete. The seller gets to dispose of the share at the right price. The other benefit is that the block share is conveniently disposed of at once.
Types of Dark Pools
Dark pools are usually not open to retail investors. However, that is slowly changing due to brokers. Usually, large transaction investors have three options. They can approach a broker, an exchange, or an independent market maker about block trading. Here is a breakdown of the types of dark pools available.
1. Broker-dealer Owned
Broker-owned dark pools are the most common. Banks and other financial institutions typically run the pools with broker-dealer licenses; the common examples include JP Morgan, Goodman Sachs, and Barclays.
Such dark pools are set up and run by the same institutions, and the order flows determine the stock prices. Most broker-dealer-owned companies mainly serve their high-value clients.
2. Agency Broker or Exchange-owned
Exchange-owned dark pools are gaining popularity. The popular stock markets own and operate these dark pools. Unlike dealer-owned forums, no actual price discovery occurs. The midpoint of the National Best Bid and Offer determines the prices. Popular exchange-owned dark pools include Instinet and Liquidnet.
3. Electronic Market Makers
Electronic market maker dark pools are owned and run by independent operators. Their platforms rely heavily on computer-based electronic trading. All trades are automated through algorithms that apply the appropriate risk levels. Like the dealer-owned pools, these platforms act on a proprietary capacity. As a result, the NBBO does not determine the prices.
Pros and Cons of Dark Pools
Dark pools are often falsely associated with illegal activities. The truth is they are legal forums that exist in the market for a good reason. However, it is not all rosy. Like everything else, it has its fair share of problems. Here are the pros and cons of dark pools.
Pros
- Private trading: The most significant advantage of dark pools is discretion. It facilitates block trading without destabilizing the market. By keeping things quiet, it prevents panic buying or selling.
- Increased efficiency: The stock market exists to serve buyers and sellers. Unfortunately, selling large quantities of shares can be a problem in the open market. Dark pools facilitate block trading allowing large firms to dispose or acquire shares with ease.
- Lower transaction cost: Selling or buying large amounts of shares can attract significant exchange fees on the open market. Dark pools deals are conducted off-market. This saves both parties involved from paying the hefty fees.
Cons
- Lack of transparency: The biggest problem with dark pools is the lack of transparency. This often works against the participant of the pool. There is usually no guarantee that the trade was executed at the best price.
- Unfair advantage: Many people view black pools as an advantage only to the wealthy. While retail investors have to adhere to market regulations, the elite can trade without much oversight. They also get better prices and are exempted from exchange fees.
Dark Pools Regulation
Dark pools don’t operate outside the law. They are nothing like the black market or the dark web. While there is still a need for more regulation, specific rules are already in place. In the U.S, the Securities Exchange Commission (SEC) regulates the dark pools. Several amendments have been made over the years to strengthen dark pool regulations.
The Regulation National Market System or Reg NMS ensures that investors get the best price for their orders. It achieves this by encouraging competition among different markets and orders. However, this same rule led to the rise of high-frequency trading – a practice that has been the subject of controversy.
Other rules consolidated under the Reg NMS include the access rule, order protection, and market data. The access rule addresses the access to market intel such as quotations. Order protection regulations under Rule 611 prevents the sale of stocks at suboptimal prices. Lastly, Sub-penny rules determine the minimum pricing increments allowed.
Final Thoughts
Dark pools are not the big bad wolves that people perceive them to be. Large institutions created them to facilitate block trading by large institutions without impacting the market.
Dark pools also provide a cost and pricing advantage to these institutions. However, the lack of transparency makes them susceptible to all kinds of illegal activities. We hope this article provides insight into this alternative trading system.