What is a Dark Pool?
A dark pool is a private financial forum or a stock exchange. Dark pools allow investors to trade without exposure until the transaction is executed. Dark pools are a type of alternative trading system that gives investors the ability to place orders and trade without publicly revealing their intentions when looking for a buyer or seller.
Understanding the Dark Pool
Dark pools emerged in the 1980s when the Securities and Exchange Commission (SEC) authorized brokers to trade large blocks of stocks. E-commerce and a 2007 SEC decision to increase competition and lower transaction costs have spurred an increase in the number of dark pools. Dark pools can charge lower fees than exchanges because they are often hosted in a large company and not necessarily a bank.
For example, Bloomberg LP owns the dark pool Bloomberg Tradebook, which is registered with the SEC. Historically, dark pools were mainly used by institutional investors for bulk transactions involving a large number of securities. However, dark pools are no longer used only for large orders. A Celent study found that the average order volume increased from 430 shares in 2009 to around 200 shares in 2020.
The main advantage of dark pool trading is that institutional investors with large trades can do so without exposure while finding buyers and sellers. This prevents a sharp devaluation of prices, which would otherwise occur. If it were known to the public, for example, that an investment bank was trying to sell 500,000 shares of a security, the security would almost certainly have lost value by the time the bank had found all buyers of their actions. Devaluation has become an increasingly likely risk and electronic trading platforms are reacting prices much faster to market pressures. However, if the new data is not communicated until after the transaction has been executed, the news has much less impact on the market.
There are several different types of dark pools: stock exchanges held by brokers or dealers, such as MS Pool by Morgan Stanley and Sigma X by Goldman Sachs; independent stock exchanges offering private transactions to their clients; and the private foreign exchange markets operated by public exchanges such as Euronext on the New York Stock Exchange. A private market will have price discovery in their own markets, but a dark pool operated by a broker gets its prices from public exchanges.
Because of their sinister name and lack of transparency, dark pools are often viewed by the public as questionable businesses. In reality, dark pools are strictly regulated by the SEC. However, there is real concern that due to the volume of transactions in dark markets, the public value of certain securities may be increasingly unreliable or inaccurate. There is also growing concern that the dark pool exchanges provide excellent fodder for high frequency predator trading (HFT).