An Introduction to Dark Pools

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.

Dark pools are not a recent phenomenon; they emerged in the late 1980s. According to the CFA Institute, non-exchange trading has taken off in the United States. Estimates show that it accounted for approximately 40% of all U.S. stock trades in spring 2017 compared with an estimated 16% in 2010. The CFA also estimates that dark pools are responsible for 15% of U.S. volume as of 2014.

Why did dark pools come into existence? Consider the options available to a large institutional investor who wanted to sell one million shares of XYZ stock before 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, for example, 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 one million sale of XYZ shares could still be sizable 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.

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 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 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.

As of May 2017, there were more than 40 dark pools registered with the SEC, of which there are 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 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.

The advantages of dark pools are as follows:

• Reduced market impact: The biggest advantage of dark pools is that market impact is significantly reduced for large orders.
• Lower transaction costs: Transaction costs may be lower since dark pool trades do not have to pay exchange fees, while transactions based on the bid-ask midpoint do not incur the full spread.

Dark pools have the following drawbacks:

• Exchange prices may not reflect the real market: If the amount of trading in dark pools owned by broker-dealers and electronic market makers continues to grow, stock prices on exchanges may not reflect the actual market. For example, if a well-regarded mutual fund owns 20% of company RST’s stock and sells it off in a dark pool, the sale of the stake may fetch the fund a good price. However, unwary investors who have just bought RST shares will have paid too much since the stock could collapse once the fund’s sale becomes public knowledge.
• Pool participants may not get the best price: The lack of transparency in dark pools can also work against a pool participant since there is no guarantee that the institution’s trade was executed at the best price. Lewis points out in Flash Boys that a surprisingly large proportion of broker-dealer dark pool trades are executed within the pools – a process known as internalization – even in cases where the broker-dealer has a small share of the U.S. market. As Lewis notes, the dark pool’s opaqueness can also give rise to conflicts of interest if a broker-dealer’s proprietary traders trade against pool clients or if the broker-dealer sells special access to the dark pool to HFT firms.

The recent HFT controversy has drawn significant regulatory attention to dark pools. Regulators have generally viewed dark pools with suspicion because of their lack of transparency, and the controversy may lead to renewed efforts to curb their appeal. One measure that may help exchanges reclaim market share from dark pools and other off-exchange venues could be a pilot proposal from the Securities and Exchange Commission (SEC) to introduce a “trade-at” rule. The rule would require brokerages to send client trades to exchanges rather than dark pools unless they can execute the trades at a meaningfully better price than that available in the public market. If implemented, this rule could present a serious challenge to the long-term viability of dark pools.

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.