Dark pools sound ominous, like dark energy or the dark side. But are they? Let's take a look at how dark pools operate and what the advantages and disadvantages are of having them part of the financial landscape.
Dark pools (sometimes referred to as the "upstairs market") are private trading venues where limited-transparency trading can take place. These are networks which allow large traders to execute orders "behind the scenes," so as to maintain pre-trade transparency and avoid issues that arise when large orders are placed through standard exchanges.
The cards are generally stacked against small retail investors, but large institutional traders do encounter some obstacles when looking to execute trades. When you or I place an order, the small volume of our trade is easily swept into the market's liquidity with only a minor, if any, impact on the price of the security. However, this is not the case for large institutional trades.
Institutional traders can move market prices dramatically when looking to enter or exit a large position. In the case of a large buy order, the order itself can drive the price of a security up as it wipes out all available shares at higher and higher prices. This works against the buyer as the average price they pay rises in conjunction with the entire order being filled. Large sell orders can have a similar impact, depressing the price and reducing the proceeds from the trade. As these large orders are placed, they can also be visible to other market participants who may adjust their positions to capitalize on the information.
As a result of the above situation, many institutions have moved towards the use of dark pools to alleviate the pricing problem associated with executing large block trades. Instead of a buyer or seller working against themselves by driving the price up or down as their trade is filled, these operators can choose to conduct their trades off the public exchanges at prices that are generally more favorable to both parties. In most cases, trades on dark pools are executed near the midpoint of the bid and ask price quoted on the public exchanges.
Dark pools solve the old problem of how to buy or sell lots of shares without moving the price. They operate in similar fashion to standard markets with regard to pricing and prioritization rules, but the major difference is that there is no market depth feed, which shows pending limit orders for traded securities. Trade information is hidden before and during trading. This allows institutions to avoid execution problems which arise after broadcasting large orders to the market, but before the trades are finalized. Once executed, all trades dark or otherwise must be reported to the consolidated tape, which is the electronic service that provides last sale and trade data for exchange-traded securities. The term "dark" only refers to the pre-trade state.
Something to keep in mind is that off-exchange trading has been around since stocks first began to trade. An institution's in-house paring of a buyer and seller which occurs outside a public exchange is similar to how a dark pool operates.
The use of dark pools has been rising in recent years in both the US and Europe (see below), but has begun to level off. It's estimated that dark pools accounted for approximately 13% of US volume in early 2013.
Proponents of dark pools will argue that the proliferation of off-exchange trading has driven down bid-ask spreads and also helped to reduce trading costs. This may be true, but the benefit of open exchanges is price discovery, which can be hampered by too much dark pool trading. If more and more trading takes place outside of public exchanges, market quality and reliability of quoted prices could deteriorate.
Dark pools are one component of a broader concept that has to do with "dark liquidity" or "hidden liquidity" trading.
Hidden liquidity trading, which is now a standard component of nearly all equity markets, refers to the ability of traders to hide some or all of their pre-trade orders on public exchanges. Typically when a trader places an order it is available for other participants to see in an "order book," assuming they have access to the information. But now nearly all exchanges allow traders to hide portions or all of their orders. The result is that market liquidity has diverged into two components: displayed and non-displayed.
Use of hidden (non-displayed) orders occurs for exactly the same reason outlined above, traders wish to shield their intentions from other opportunistic participants until the trades are executed. In general, a non-hidden (displayed) order will take precedence over a hidden order for a given price, but the existence of hidden orders reduces transparency in the marketplace. The use of hidden orders means that the best prevailing buy and sell prices may not be accurately represented by the bid and ask prices.
According to Rhodri Preece of the CFA Institute, non-displayed (hidden orders) accounted for roughly a third of all volume in the US at the beginning of 2013. Remember however that these trades are only hidden until execution, when the pricing information is recorded.
One of the fundamental tenets of Dow Theory is that the price of a given asset at any point in time represents the sum total of all investors knowledge, desires, fears, motivations etc. As we commonly say, the price discounts all available information. Thus the publicly available price should represent the "correct" or "fair" value, given that any desire to own or sell the security has been factored into the available public price. So the important question for technical analysts is, "Does the use of dark pools undermine the validity of the publicly available price of an asset?"
Thankfully (and necessarily) the answer to this question is no. Trades within dark pools are recorded once finalized, and as I mentioned, often occur between the current bid and ask price. Arbitragers and high-frequency algorithms, which are exceedingly being allowed to operate within dark pools, would arbitrage any price difference between privately transacted prices and the public price.
The following is an excerpt of Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
