Dark Pool: How They Work and Why They’re Controversial

What Is a Dark Pool?

Dark pools are private exchanges allowing anonymous securities trading, offering benefits for institutional investors like price stability in large trades. With their origins in the 1980s, these systems gained prominence after regulatory changes in 2005, increasing competition in financial markets. Yet, their lack of transparency raises concerns related to market impact and manipulation.

Evolution and Key Functions of Dark Pools in Trading

Dark pools emerged in the 1980s when the Securities and Exchange Commission (SEC) allowed brokers to transact large blocks of shares. Electronic trading and an SEC ruling in 2005 that was designed to increase competition and cut transaction costs have stimulated an increase in the number of dark pools. Dark pools can charge lower fees than exchanges because they are often housed within a large firm and not necessarily a bank.

For example, Bloomberg LP owns the dark pool Bloomberg Tradebook, which is registered with the SEC. Dark pools were initially mostly used by institutional investors for block trades involving a large number of securities. However, dark pools are no longer used only for large orders. A 2013 report by Celent found that as a result of block orders moving to dark pools, the average order size dropped about 50%, from 430 shares in 2009 to approximately 200 shares in four years.

The primary advantage of dark pool trading is that institutional investors making large trades can do so without exposure while finding buyers and sellers. This prevents heavy price devaluation, which would otherwise occur. If it were public knowledge, for example, that an investment bank was trying to sell 500,000 shares of a security, the security would almost certainly have decreased in value by the time the bank found buyers for all of their shares. Devaluation has become an increasingly likely risk, and electronic trading platforms are causing prices to respond much more quickly to market pressures. If the new data is reported only after the trade has been executed, however, the news has much less of an impact on the market.

How High-Frequency Trading Influences Dark Pools

Supercomputers that can run algorithms in milliseconds have made high-frequency trading (HFT) a major part of daily trading. HFT technology lets institutional traders quickly place large orders and benefit from small price changes. HFT traders quickly take profits and close their positions after executing orders. This “legal piracy” happens multiple times a day, generating large profits for HFT traders.

Eventually, HFT became so pervasive that it grew increasingly difficult to execute large trades through a single exchange. Because large HFT orders had to be spread among multiple exchanges, it alerted trading competitors who could then get in front of the order and snatch up the inventory, driving up share prices. All of this happened within milliseconds of placing the order.

To keep large trades private and ensure liquidity, investment banks created dark pools. Dark pools offer liquidity for traders with large orders who can’t or don’t want to use public exchanges. By Feb. 28, 2022, there were 64 dark pools in the U.S., primarily run by banks.

Addressing Challenges and Controversies in Dark Pools

Trading in dark pools is legal, but lacks transparency Those who have denounced HFT as an unfair advantage over other investors have also condemned the lack of transparency in dark pools, which can hide conflicts of interest. Due to complaints, the SEC conducted research and presented their 2015 report, scrutinizing dark pools for illegal front-running when institutional traders place their orders in front of a customer’s order to capitalize on the uptick in share prices. Advocates of dark pools insist they provide essential liquidity, allowing the markets to operate more efficiently.

Exploring Notable Dark Pool Examples and Their Impact  

There are several different types of dark pools: broker or dealer-owned exchanges, such as Morgan Stanley’s MS Pool and Goldman Sachs’ Sigma X; independently owned exchanges offering private trading to their clients; and private exchange markets operated by public exchanges such as the New York Stock Exchange’s Euronext. A privately-owned market will have price discovery within their own markets, but a dark pool operated by a broker derives its prices from public exchanges.

Due to their name and lack of transparency, dark pools are often viewed as suspicious by the public. In reality, dark pools are tightly regulated by the SEC. However, there is a real concern that because of the sheer volume of trades conducted on dark markets, the public values of certain securities are increasingly unreliable or inaccurate. There is also mounting concern that dark pool exchanges provide excellent fodder for predatory high-frequency trading.

The Bottom Line

Dark pools serve as private trading venues where institutional investors can execute large orders with anonymity, minimizing market impact and protecting against price devaluation. They emerged in the 1980s, gained traction following SEC regulations in 2005, and cater to the needs of high-frequency traders. While they provide crucial liquidity, critics argue that their opaque nature raises concerns about transparency and potential market manipulation. Despite these controversies, dark pools remain an integral part of modern securities trading, balancing the need for confidentiality with regulatory oversight.