Dark Pools – Taking a Deep Dive into the Stock Market’s Underworld – Part 1

The chances are you probably won’t learn about what they are in a finance degree or even an MBA. In fact, the only way you will learn about them is if (a) you’re an experienced trader, (b) you have a genuine interest in understanding the market’s structure or (c) you watched season 4 of Billions.

The logic behind dark pools is not hard to understand per se. The tricky part is understanding the mechanics behind them. To facilitate the understanding of the reader, this article is separated in two parts. The first part, this article, will tackle what dark pools are, the history of dark pools and if we should worry about them. The second article that will be released in the future will be an extension to this article. I will analyse the mechanics behind dark pools, what they are used for, their advantages and disadvantages, as well as their connection with high frequency traders. So, let’s get started.

What are Dark Pools?

Dark pools are essentially private exchanges for trading securities, meaning that they are not available for typical retail investors [1]. If we picture an iceberg and placed all the different capital markets, all the different types of investors and traders, all the asset classes, all the financial regulators and everything else that belongs to the market’s ecosystem, we get all the “systems” that are publicly available for us to see. Below the water, there would be more iceberg, but we wouldn’t be able to see it from the surface – this is where dark pools would be.

Dark pools are a way for investors to hide their trades from the total exchange. Don’t get me wrong here; dark pools are not some sort of “black market”. These exchanges are so named due to their lack of transparency, meaning that investors have the opportunity to place orders and make trades without the general public knowing about it. You are probably wondering “if they aren’t public, then where can I find them?”. The irony of dark pools is that they’re not a secret at all. In fact, anyone with a username and password to Bloomberg Terminal has access to Bloomberg’s Tradebook and voilá: dark pool [2]. However, Bloomberg’s dark pool is an “aggregator” and is only one of many types of dark pools. I will tackle the different kinds in the second article.

The second thing you must be wondering is, “surely if dark pools are a way for investors to hide their trades, they have to be somewhat illegal right?”. The answer is no – mostly. No, because the purposes and usages of dark pools are more for preventing certain liquidity issues with securities. For the majority, they actually allow deep-pocketed investors to do some pretty cool stuff without doing too much damage to a stock’s market value (or any other asset class). For example, if a hedge fund has strong evidence to believe a buyout between two large companies will happen, they might place a trade through a dark pool using a block trade if they want to trade a huge number of shares – and we’re not talking about 100 or 200 thousand shares. If regular investors knew about the merger, the stock would rally since everyone would load up on that stock, meaning the hedge fund wouldn’t profit as much. That way, dark pools also serve as a protection mechanism to avoid mispricing due to a large volume of orders. Without getting too much into detail, dark pools are mainly used when you want to move size, and anonymity is key – they have nothing to do with other trading methods like arbitrage. That’s why it’s useful to interpret them simply as shares bought or sold in the dark. Of course, an issue arises when traders start misusing dark pools for personal benefit, especially for insider trading – but let’s leave that for the SEC to deal with.

In summary, dark pools are private exchanges that allow large volumes of securities to be transacted without the underlying asset being too affected. They can be a protection mechanism as much as they can be used for wrongdoing. This doesn’t necessarily make dark pools illegal, but in the eyes of regulators it most likely makes them frowned upon – but that’s because regulators probably don’t understand how dark pools work. Quoting CNBC, “the biggest reason people are afraid of “Dark Pools” is the name, like a kid being stuck in a closet by a mean sibling, the image is frightening. Maybe they should be called “Block Trading Venue for Institutional Traders Who Know What They are Doing”” [4].

The History of Dark Pools

Dark pools weren’t created by means of an idea, nor were they created out of necessity to create an exchange where “big boys” could play. In fact, they weren’t always called dark pools. In 1979, the SEC enacted rule 19c-3 which stated that any security listed on a given exchange could be actively traded off the exchange in which it was listed [5]. The keyword here is “off” – initially, off-exchange securities trading was called “upstairs trading” and only represented a small portion of total trading activity.

In 1986, company called Instinet started the first dark pool trading venue known as “After Hours Cross”. Initially, dark pools only worked after closing bell meaning that at 6:30pm, Eastern Standard Time, an algorithm would match buyers and sellers using the security’s closing price for the session as means of settlement [6]. The number of entities interested in providing dark pool trading venues expanded aggressively in the late 1980’s and continued throughout the 1990s.

Currently, there are more than 40 dark pools active in the US alone. This number may seem small, but it’s not – the reason why it’s not is because over 15% of the total traded volume of equity shares in the US market are attributed to dark pools. If this percentage seems somewhat small, well, it’s not. According to data from the world bank [7], $68.2 trillion worth of shares were traded in 2018. This means that 200 billion shares worth approximately $10 trillion are traded annually via dark pools [8].

Should We Worry About Dark Pools?

The answer to this question depends on what we mean by “worry”. Should we worry that dark pools suddenly suck up all the money we have invested in securities? No – dark pools are highly regulated by the SEC. There is a misconception that dark pools are like wild horses and can do anything they want. That’s not true. All dark pools are registered broker-dealers with the SEC and FINRA (Financial Industry Regulatory Authority), and are subject to regular audits and examinations just like a regular exchange. In fact, the SEC recognizes the importance for institutions to be able to work orders without displaying the whole information in the markets, but it doesn’t allow dark pools to be used for market manipulation in any way.

Should we worry that dark pools misprice securities? There is a risk yes, but it’s a small one, and mispricing doesn’t normally occur. What do I mean by this? Yes, off-market prices may be far from the public market, but that’s because dark pools have very large players. It’s sort of an “economies of scale” approach to investing: the more you buy, the cheaper it is. We must not forget that dark pools came into existence to significantly reduce the market impact of large orders. They weren’t created as a market manipulation tool. Institutional investors and traders contend with the fact that markets move adversely when securities are bought or sold in large blocks. As a result, they may end up paying more than they would like for a transaction, and receive lower prices than they may expect.

The public market’s feature of “complete transparency” does not work to the advantage of large investors since everyone can visualize their trading intentions. What do I mean by this? If an investor bought 500,000 shares of company X at $5, the overall impact would be larger than if I, an institutional investor bought only 500 at $5. It takes large amounts of capital to make more significant movements in a company’s stock price, so if news broke that the investor interested in company X was going to buy 500,000 shares, the public market would load up faster than the time it would take for the investor to buy these shares, hence reducing the total profit the investor could make. In contrast, because dark pools are not accessible to the public and are completely opaque, large block trades can be crossed without retail investors coming in and wiping out the value of the stock – paradoxically, mispricing is more likely to occur because of institutional investors rather than dark pool investors. Therefore, trades executed in dark pools will have very limited market impact compared with similar trades executed on public exchanges.

Concluding Remarks – How Should We Think About Dark Pools?

We shouldn’t think about them at all – to an extent. The same way we are taught that algebra, calculus and statistics are branches of mathematics, dark pools are a branch of the overall market structure. Here’s a neat graph that summarizes the market structure in the U.S:

As you can see, dark pools are deeply embedded in the market structure, hence why they may seem like some sort of enigma to investors with little experience. The reality is, they’re not – in fact, their existence serves a very big purpose in the functioning of financial markets. In a way, dark pools are just there – they exist. So, what are the key takeaways from part 1? First, dark pools are private exchanges for trading large amounts (blocks) of securities. Second, dark pools reduce the market impact of large orders, meaning that securities don’t gain or lose too much value. Third, as long as they operate within certain parameters, dark pools are completely legal.