OTC vs Exchange vs. Dark Pool Trading: What is the Dark Pool?

Imagine if a multi-billionaire investor wanted to sell 100,000 shares of company ABC. Tamta is a content writer based in Georgia with five years of experience covering global financial and crypto markets for news https://www.xcritical.com/ outlets, blockchain companies, and crypto businesses. With a background in higher education and a personal interest in crypto investing, she specializes in breaking down complex concepts into easy-to-understand information for new crypto investors.

Order aggressiveness in limit order book markets

It is important to note that dark pools operate within the boundaries of existing securities laws, and any violations are subject to legal consequences. Therefore, in order to avoid excessive market swings and possible manipulation, investment banks and large financial corporations created private exchanges. These closed marketplaces have less transparency to mitigate their impacts on market prices, hence the name of dark pools. The risks of attracting attention from other traders have intensified what is dark pool with the rise of algorithmic trading and high-frequency trading (HFT). These strategies employ sophisticated computer programs to make big trades just ahead of other investors. HFT programs flood public exchanges with buy or sell orders to front-run giant block trades, and force the fund manager in the above example to get a worse price on their trade.

Optimal order execution using hidden orders

Dark pools are privately organized exchanges that are used to trade financial securities. Unlike traditional exchanges, dark pools aren’t available to everyday retail investors. Instead, they’re meant for institutional investors who regularly place large orders for their clients. The purpose is to avoid affecting the market when these large block orders are placed. This allows them to make trades without having to explain their rationale as they look for buyers or sellers.

Agency Broker or Exchange-Owned Dark Pool

Estimates show that it accounted for approximately 40% of all U.S. stock trades in 2017 compared with roughly 16% in 2010. The CFA also estimates that dark pools are responsible for 15% of U.S. volume as of 2014. Dark pool operators must report trade details to regulators and disseminate consolidated post-trade information to the public.

What are “dark pools,” and why are they dangerous?

This aspect of dark pool trading can be particularly beneficial when it comes to minimizing market impact costs and achieving efficient trade execution. Institutional investors avoid the market impact that comes with trading large volumes of shares on public exchanges by using dark pools. This is because when a large trade is executed on a public exchange, it can signal to the market that there is significant buying or selling pressure, which can cause the price of the stock to move against the trader. ATS, especially dark pools, allow large institutional investors to trade without revealing their trading intentions to the public, which can help to reduce market impact. ATS also provides traders with the flexibility to execute trades without having to follow strict rules and regulations that are imposed in traditional stock exchanges.

• Examples of dark pools include Barclays LX, Credit Suisse Crossfinder, and UBS PIN Alternative Trading System.
• Dark pools, sometimes referred to as “dark pools of liquidity,” are a type of alternative trading system used by large institutional investors to which the investing public does not have access.
• They require dark pools to register with them and comply with the same regulatory requirements as public exchanges.
• Later, in the mid-2000s, further SEC changes that were meant to cut trading costs and increase market competition led to an increase in dark pool trading.
• As prices are derived from exchanges–such as the midpoint of the National Best Bid and Offer (NBBO), there is no price discovery.
• As the financial landscape continues to evolve, it is crucial for regulators to remain vigilant and adaptive to maintain a well-regulated and functioning marketplace.

[One disadvantage of EMM dark pools is that they are more vulnerable to high-frequency trading strategies and aggressive traders, which can lead to market manipulation and unfair advantages for certain traders. This led to the development of dark pools, which are essentially private versions of these electronic communication networks. Dark pools have become an integral part of the global financial system today, with billions of dollars worth of securities traded on these private exchanges daily. 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.

They are private trading platforms in the stock market, where large institutional investors can trade securities anonymously, outside of public exchanges. Dark pool attract high-frequency traders looking to take advantage of market inefficiencies since they operate in secrecy. They are be factored into the overall market price of a stock since dark pool trades are not reported to public exchanges, which lead to discrepancies between the public exchange price and the true market price.

These traders are now referred to as “Flash Boys” because of author Michael Lewis’s best-selling book about them of the same name. By using ultrafast telecom links, microwave towers and special access to the exchanges, the Flash Boys are able to gain an edge over other traders. They can buy or sell large amounts of stock in the microseconds before a regular investor does, which means that investor either has to pay more to buy or accept less to sell. With the implementation of MiFID II in Europe earlier this year (more to come on this topic in later blogs), the EU is pushing for more transparency and for more activity to take place on public exchanges.

This can be particularly beneficial for institutional investors who wish to keep their trading strategies and intentions confidential. There are many critics of HFT since it gives some investors an advantage that other investors cannot match, especially on private exchanges. Conflicts of interest and other unethical investing practices can be hidden in dark pools as well. Since HFT floods the trading volume on public exchanges, the programs need to find ways to break larger orders into smaller ones.

There are three types, including broker-dealer-owned dark pools, agency broker or exchange-owned dark pools, and electronic market markers dark pools. In contrast to dark pools, traditional exchanges are sometimes described as lit markets. However, private exchange operators claim that dark pool liquidity is higher than public markets, especially for high-frequency traders. In 2022, the SEC proposed a rule that would require dark pool operators to execute market orders in public secondary markets rather than privately unless an evident price advantage was offered in dark pools.

There are those who lose out because of the presence of HFT in the markets – they are the traditional market makers who have chosen not to adopt the new technology (you can read more about this in our blog ). Institutional investors (as has been widely covered of late) have benefited from the reduction in transaction costs that have resulted from the practice of electronic market making. You can think of the integrated order types as essentially a trip wire for information.

Without transparency, it is challenging to ensure that all market participants are treated equally but I don’t think anyone has ever been under that illusion. Privately held pools and mutual funds provide several perks for large corporations, benefiting from trading with minimum transparency and other advantages. By February 2020, over 50 dark pools were reported by the SEC in the United States.

There was a change in the regulation in the US in regard to the transaction of securities which enabled investors to trade large volumes of shares without having to compromise their privacy. The concept of dark pools was first introduced by the investment bank Credit Suisse in 1998. The first successful dark pool was operated by Instinet (now owned by Nomura Holdings) in 2002. Dark pools are private exchanges for trading securities that are not accessible to the investing public. Also known as dark pools of liquidity, the name of these exchanges is a reference to their complete lack of transparency. With the advent of supercomputers capable of executing algorithmic-based programs over the course of just milliseconds, high-frequency trading (HFT) has come to dominate daily trading volume.