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What Are Dark Pools?

Dark pools are networks of privately held trading forums, exchanges or markets that provide a platform for the anonymous trading of securities. Dark pools facilitate non-exchange-based trading practices between broker-dealer firms and investors interested in placing orders for the trade of specific securities outside of public scrutiny. Dark pools are also referred to as "dark pool liquidity" or "dark liquidity."[1]

Purpose Of Dark Pools

The main objective of a dark pool is to provide traders with the ability to have their orders filled according to the ideals set forth in the National Best Bid and Offer (NBBO) regulation. The NBBO is defined by the United States Securities and Exchange Commission (SEC) as being the best current bid and offer price available for an exchange-based security.[2]

Having an order filled according to NBBO is especially important to institutional traders engaged in the trading of large blocks of securities. The pricing of securities offered by a public exchange can become compromised when the large order hits the open market. Through processing the transaction in private, the institutional trader is able to realise a desirable price for the trade without worrying about having to pay a premium to the market.

For instance, if investment bank ABC wanted to buy 1 million shares of company XYZ to diversify their equities portfolio, the purchase would likely have an impact upon the current market price of XYZ. However, if the transaction is conducted in a dark pool, out of the trading public's view, then the trade is executed without creating any abnormal volatility in the marketplace.

History Of Dark Pools

The origin of dark pools can be dated back to 1980 and the enactment of SEC Rule 19c-3. It states that any security listed on a given exchange after April 26, 1979 may be actively traded off the exchange in which it was listed.[3] Initially, the off-exchange trading of securities was referred to as "upstairs trading" and represented a small portion of total trading activity.

In 1986, the company Instinet started the first dark pool trading venue known as "After Hours Cross." It was an off-exchange marketplace where customers entered orders during the day, and at 6:30 p.m. Eastern Standard Time, an algorithm matched buyers with sellers using the security's closing price for the session as means for settlement.[4] In contrast to the public exchange trading of the time, After Hours Cross-enabled market orders that were not filled to remain private information, and accordingly gained favour among specific investor demographics.

After Hours Cross was popular among volume traders, and in 1987, the company ITG created the first intraday dark pool "POSIT."[5] Instead of matching trades using the session's settlement price as the basis for trade execution, POSIT matched equity trades according to the midpoint of the NBBO. The popularity of POSIT among investors sparked competition, and the number of entities interested in providing dark pool trading venues expanded aggressively beginning in the late 1980s and continued throughout the 1990s.

There are roughly 40 dark pools operational in the United States. Over 15% of the total traded volume of equity shares in the US markets are attributable to dark pools. This is a considerable amount of trade, as it's estimated to encompass over 200 billion shares of exchange-based stocks worth US$10 trillion annually.[6]

Types Of Dark Pools

Dark pools are classified by the provider of the trading venue. Each type of dark pool is a unique trading atmosphere that offers different incentives according to the demographic of the market participant. Although the objective of each venue is to create liquidity and provide a service to the trader, each type of dark pool has select attributes that may or may not benefit all customers.

There are three basic types of dark pools:

  • Independent: Independent dark pools are run by individual companies. Independent providers routinely offer lower transaction costs and reduce costs associated with low liquidity. Instinet, ITG and Smartpool are examples of independent dark pool providers.
  • Broker-Dealer Owned: Broker-dealer owned dark pools are typically run by investment banks. These pools offer price improvement through NBBO and specialise in trade involving other banks or "buy-side" participants. JPMorgan Chase, Barclays Capital and Credit Suisse are a few examples of broker-dealer dark pool providers.
  • Exchange Owned: Exchange-owned dark pools provide access to retail traders interested in off-exchange trading. They are receptive to high-frequency trading practices and often provide increased liquidity to market participants. Examples of exchange-owned dark pool providers are NYSE Euronext, BATS Trading and the International Securities Exchange (ISE).[7]

Advantages

Actively investing or trading securities in a dark pool affords the market participant several distinct advantages over exchange-based trading. Depending upon the investor or trader, the use of dark pools may be a worthwhile endeavour, and a contributor to overall profitability.

Superior trade execution is one advantage enjoyed by traders operating within a dark pool. While true that not every order placed in a dark pool is filled, the execution price of an order is the trader's desired value. In contrast, public exchanges are prone to order fill issues and slippage related to volatility caused by a sudden spike in volume. In dark pools, this problem is mitigated, as pricing data is not visible, thus the trader's order is either filled at price or it is not.

Anonymity within the marketplace is another advantage to conducting trading operations via dark pool. In contrast to public exchanges, pending market orders for a given security are not publicly visible. This fact is important to the trader placing the order, as competing traders cannot devise strategies to front run or "game the market" ahead of the order being filled.

Disadvantages

Since inception, the role of dark pools in the global marketplace has been an often debated topic among financial industry professionals. Drawbacks ranging from the potential impact upon exchange-based trading activities, to disadvantages realised by the dark pool participants themselves, have been cited as reasons to bolster regulation facing the industry.

One of the main drawbacks related to dark pools is the draining of liquidity from exchange- based trading enterprises. As dark pools have become larger, the liquidity taken from public trading venues has become more substantial. The potential compromise of open market price discovery is cited as being the main concern associated with the growth and expansion of dark pools. In the event that lower liquidity becomes an epidemic among exchanges, then bid/ask spreads inevitably increase. This scenario leads to higher transaction costs for participants in public markets as well as a decrease in overall market efficiency.

Perhaps the most frequently cited disadvantage attributed to dark pools is the potential for investment fraud and predatory trading activities. As a result of the lack of transparency, concerns over the ethical use of high-frequency trading strategies and potential market manipulations by participants have been cited as factors in the creation of an "uneven" playing field.

In accordance, many broker-dealers have been financially penalised for misleading investors on the tenants of how their dark pool trading platform was managed. Investment banks Barclays and Credit Suisse are examples of broker-dealers that have been fined by the SEC, with amounts totaling US$154 million.[8]

Summary

Since the inception of off-exchange trading in 1980, the industry has grown exponentially. Daily volumes of traded financial securities via dark pools now represent a substantial portion of total trading activity worldwide. Although under intense scrutiny aimed at reform, the use of dark pools for the facilitation of trade remains a viable part of the financial industry.

Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. FXCM will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.