Dark Pool

A privately organized financial exchange or hub where securities, derivatives, and other financial assets are traded.

Author: Matthew Retzloff
Matthew Retzloff
Matthew Retzloff
Investment Banking | Corporate Development

Matthew started his finance career working as an investment banking analyst for Falcon Capital Partners, a healthcare IT boutique, before moving on to work for Raymond James Financial, Inc in their specialty finance coverage group in Atlanta. Matthew then started in a role in corporate development at Babcock & Wilcox before moving to a corporate development associate role with Caesars Entertainment Corporation where he currently is. Matthew provides support to Caesars' M&A processes including evaluating inbound teasers/CIMs to identify possible acquisition targets, due diligence, constructing financial models, corporate valuation, and interacting with potential acquisition targets.

Matthew has a Bachelor of Science in Accounting and Business Administration and a Bachelor of Arts in German from University of North Carolina.

Reviewed By: Manu Lakshmanan
Manu Lakshmanan
Manu Lakshmanan
Management Consulting | Strategy & Operations

Prior to accepting a position as the Director of Operations Strategy at DJO Global, Manu was a management consultant with McKinsey & Company in Houston. He served clients, including presenting directly to C-level executives, in digital, strategy, M&A, and operations projects.

Manu holds a PHD in Biomedical Engineering from Duke University and a BA in Physics from Cornell University.

Last Updated:December 18, 2023

What is a Dark Pool?

A dark pool, also known as a black pool or alternative trading system, is a privately organized financial exchange or hub where securities, derivatives, and other financial assets are traded.

Securities traded on these private exchanges cannot be accessed through public exchanges like NASDAQ or the New York Stock Exchange. Hence, trades made through these exchanges do not impact the public market.

For this reason, dark pools benefit investors who want to remain anonymous and out of the purview of the public.

The name of these exchanges alludes to the complete lack of transparency that accompanies their trades. 

This lack of transparency also exposes trades to possible conflicts of interest and predatory trading tactics by high-frequency traders. 

However, they are monitored and regulated by the Securities and Exchanges Commission (SEC). Therefore, despite their lack of transparency, they must follow basic trading laws laid out by the SEC to continue their operations.

Although black pools are frequently viewed negatively, they serve a useful purpose by enabling massive trades without influencing the broader market.

They were originally developed to make block trading possible for institutional investors that did not want to disrupt the markets with their massive orders and receive unfavorable trade prices.

As of February 2022, there are 64 registered alternative trading systems in the US.

Key Takeaways

  • A dark pool is an exchange or hub for trading securities, derivatives, and other financial products. 
  • It is privately organized and especially useful for institutional investors wishing to place large transactions without influencing the market.
  • The identity of a trader and details about the sale or purchase of securities remain hidden until the transaction is completed.
  • There are three types, each of which serves a different purpose - broker-dealer owned, agency-broker or exchange owned, and electronic market makers.
  • Although these private exchanges may appear advantageous at first glance, they have shortcomings that have attracted regulatory attention over the years.
  • The lack of transparency associated with black pools is a major cause of concern for regulatory authorities and can have an adverse impact on the overall efficiency of financial markets.

Uses of Dark Pools

Dark pools first appeared in the late 1980s. However, according to the CFA Institute, non-exchange trading has recently grown in popularity in the United States. As of 2014, black pools accounted for 15% of the US stock trade volume.

This leads us to the question - why were these exchanges created in the first place?

To answer this question, let us consider a hypothetical example. Suppose Seema wants to sell one million shares of PQR Corp. However, non-exchange trading has not yet been introduced.

In this case, Seema has three options available to her. They are as follows:

  1. She can execute the sale through a floor trader over a day or two and hope for a good price.
  2. She can split up the order, selling, for example, 200,000 shares every day for five days.
  3. Sell smaller amounts of the shares until she can find a big buyer who is willing to purchase the outstanding amount.

Regardless of Seema's choice, the market impact of selling a million shares of PQR Corp is still significant. Transaction via a stock exchange cannot be conducted in a way that keeps the investor's identity or purposes discrete.

If Seema opts for choices 2 or 3, she faces the risk of a sharp price decline while she waits to complete the sale, as more investors become aware of her intentions.

Alternative trading systems can help resolve such issues.

Dark Pool Functions

These pools work like any other trading platform; the only difference is that they are private, whereas other exchanges are typically public. 

Unlike these exchanges, the identity of traders on alternative trading systems is hidden when transactions are executed.

This lack of transparency can work in favor of large institutional investors as they are more likely to get a better price on a sale via a black pool vs. a normal exchange.

Public exchanges get a lot of media interest and are subject to stricter regulations. As a result, everyone is aware of who is trading what, and if one waits a long time before the transaction is finished, this may impact on prices.

Details of a trade made on a black pool are only published publicly after the trade has already been executed. The delay plays to the advantageousness of these systems.

An institutional seller is more likely to find a buyer for all shares on a black pool than a normal exchange since these pools cater to bigger investors. They also offer reduced transaction fees for investors, making them more attractive.

The Securities and Exchange Commission (SEC) of the United States introduced Rule 19c-3 in 1979. It permitted businesses to exchange assets in over-the-counter markets. 

Further, the SEC ruling in 2007 increased the number of dark pools in the US and significantly boosted trade access.

Examples of Dark Pools

To strengthen our understanding of alternative trading systems, let us consider the following hypothetical example.

Suppose Ophelia is an executive at a major automotive company. She owns a large portion of their shares and wishes to sell half. However, if she sells these shares, it would garner media interest and adversely impact the company.

To protect her identity and avoid public scrutiny of the company, she can execute her sale through a dark pool.

By doing so, the stocks of the automotive company will not rapidly fall in value as she sells them. Instead, investors will only know about the sale once it has been executed.

Similarly, an institutional investor can also use alternative trading systems to buy a large portion of shares in a company.

If individuals know that a prominent institutional investor is purchasing shares in a company, they are likely to follow its lead. This causes the share price to rise before the institution can complete its purchase.

In this case, using a dark pool avoids this surge in stock price until the investor and the institutional investor have completed the transaction and bought or sold the desired number of shares.

types of Dark Pools

As mentioned previously, there are 60 dark pools in the US as of February 2022. However, they are not all the same. They differ in several aspects and can be categorized into three different types. 

The following section briefly discusses each one.

  1. Broker-dealer owned: Broker-dealers create these for their clients, and proprietary trading may be included. Their prices are determined by their order flow, i.e., price discovery is present in these private exchanges. Goldman Sachs’ Sigma X, Morgan Stanley’s MS Pool, Credit Suisse's CrossFinder, and Citibank’s Citi-Match are all examples of a broker-dealer-owned alternative trading system.
  2. Agency-broker or exchange owned: The prices for these trading systems are derived from exchanges. For this reason, they behave more like agents than principals, and there is no price discovery. Their prices are calculated by the National Best Bid and Offer (NBBO). ITG Posit, Instinet, and Liquidnet are some examples of agency-broker alternative trading systems. NYSE Euronext and BATS Trading are examples of exchange-owned alternative trading systems.
  3. Electronic Market Makers: Independent operators like Knight and Getco offer these. Like broker-dealer-owned black pools, they have price discovery as the NBBO does not calculate their prices.

Dark Pools Pros and Cons

Like any other aspect of the financial market, these also have advantages and disadvantages. The following section goes over some of these advantages and limitations.

Pros & Cons
Pros Cons
Stocks can be bought or sold in large volumes without impacting the overall market. The stock prices on public exchanges may not correctly reflect what is happening in the real market, as transactions are only made public upon completion.
Exchange fees are omitted from dark pool trades; hence, overall transaction costs are likely to be lower. It could result in conflicts of interest if a broker-dealer sells high-frequency trading businesses exclusive access to the dark pool or if its proprietary traders transact against clients of the pool.
Identity can be hidden during transactions. This is especially beneficial for well-known institutional investors who do not want to influence market psychology. The lack of transparency could result in inefficiencies in the market for equities.
High-frequency trading mechanisms allow these private exchanges more liquidity than a public exchange. High-frequency traders may partake in unethical investment practices, profiting from the downfall of other companies. This is especially a concern since the trader’s identity is hidden.

Critiques of Dark Pools

Although these trading systems are regulated by the SEC, their lack of transparency has become a point of contention over the years.

High-frequency trading firms are especially likely to take advantage of the opaque nature of private exchanges and engage in predatory practices. 

Additionally, black pool operators have been charged with misleading their clients or utilizing their dark pool data to trade against other customers.

In fact, The Wall Street Journal has reported that since 2011, dark pool operators have been asked to pay upwards of $340 million to securities authorities to resolve various litigation claims.

Black pool trades now average less than 150 shares. 

Public exchanges like the NYSE, trying to regain some of the trading market shares they have lost to alternative trading systems, claim that these small deals mean that alternative systems aren’t as needed as one might think.

Dark pools have also been the center of controversies in the financial world. One case is that of the London-based bank Barclays.

Barclays came under fire when the state of New York filed a lawsuit against the bank for allegedly defrauding and deceiving investors through its black pool in June 2014.

One of the main claims in the lawsuit was that Barclays misled other clients about the degree of aggressive HFT activity in its private exchange.

In its complaint, the state said that former bank executives were helping it and were suing for unspecified damages. 

The bank informed the London Stock Exchange that it was taking the allegations seriously and was working with the New York attorney general after the news of the lawsuit caused its shares to plummet by 5%.

The next month, Barclays asked for the lawsuit to be dismissed, claiming no fraud, no victims, and no harm done to anyone. 

The office of the New York Attorney General (NYAG) declared that it was certain the move would be unsuccessful.

Eventually, in January 2016, the bank agreed to pay a $35 million punishment to the SEC and a $70 million fine to the NYAG for its transgressions.

Researched and authored by Rhea Bhatnagar LinkedIn

Reviewed & Edited by Ankit Sinha | LinkedIn

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