An Introduction To Dark Pools
Dark pools are an ominous-sounding term for private exchanges or forums for trading securities; unlike stock exchanges, dark pools are not accessible by the investing public. Also known as “dark pools of liquidity,” they 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 consequently obtain adverse prices for their trades. While dark pools have been cast in a very unfavorable light in Michael Lewis’ bestseller “Flash Boys: A Wall Street Revolt,” 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
Rationale for dark pools
The current controversy surrounding dark pools may lead one to think that they are a recent innovation, but they have actually been around since the late 1980s. Non-exchange trading in theU.S. has surged in recent years, accounting for about 40% of allU.S. stock trades in 2014 compared with 16% six years ago. Dark pools have been at the forefront of this trend towards off-exchange trading, accounting for 15% ofU.S. volume as of 2014, according to figures given by industry insiders.
Why did dark pools come into existence? Consider the options available to a large institutional investor who wanted to sell 1 million shares of XYZ stock prior to the advent of non-exchange trading. This investor could either:
(a) work the order through a floor trader over the course of a day or two and hope for a decent VWAP (volume weighted average price);
(b) split the order up into say five pieces and sell 200,000 shares per day, or
(c) sell small amounts until a large buyer could be found who was willing to take up the full amount of the remaining shares.
The market impact of a 1-million sale of XYZ shares could still be sizeable, regardless of whether the investor chose (a), (b), or (c), since it was not possible to keep the identity or intention of the investor secret in a stock exchange transaction. With options (b) and (c), the risk of a decline in the period while the investor was waiting to sell the remaining shares was also significant. Dark pools were one solution to these issues.
Why Use a Dark Pool?
Contrast this with the present-day situation, in which an institutional investor uses a dark pool to sell a 1 million share block. The lack of transparency actually works in the institutional investor’s favor, 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 prior to 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 getting 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 get a whiff of the investor’s trading intentions.
Types of dark pools
As of April 2014, there were 45 dark pools in the US, consisting of the following three types:
- 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, of which there were 19 as of April 2014, 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.