Table of Сontents
- What Is a Dark Pool?
- How Dark Pool Trading Works
- Dark Pools & Payment For Order Flow
- Uses for Dark Pool Trades
- Dark Pool Trading Regulations
- Pros & Cons of Dark Pool Trading
- How To Spot Dark Pool Activity
- Bottom Line
- FAQ
An alternate market called a “black pool” allows institutions to purchase and sell shares with some distinctions from transactions made on regular public stock exchanges.
What Is a Dark Pool?
Institutions can trade assets in a dark pool, a secret market, without first sending their orders through a stock exchange that is open to the public. Off-market trading started in the late 1960s, according to a statement from the SEC. Alternative trading systems (ATS), on the other hand, became well-known in 2005 after the SEC passed Regulation NMS, which clarified the legal basis for off-exchange trading.
These trading forums are frequently referred to as “dark pools” in layman’s terms. Dark pools are seen negatively by many investors, and in some situations, that attitude is reasonable. A dark pool, however, is really just a secret market where investors may trade shares without those transactions being visible on a significant stock exchange.
How Dark Pool Trading Works
These dark pools essentially serve the same purpose as standard stock exchanges in that they connect buyers and sellers. They do, however, provide certain benefits for institutions. One reason is that, unlike on public exchanges, bids and offers aren’t frequently quoted, which makes it simpler for giant mutual or hedge funds to trade enormous blocks of stock without causing the market to tremble.
The price of the securities would probably drop significantly as other traders competed to sell the order of 5 million shares if a mutual fund placed a sell order on the Nasdaq. By listing that block of shares in a dark pool, you may avoid alerting other market players. Heavy traffic in a dark pool leads to the delayed posting of trade outcomes outside of the pool as well.
Dark Pools & Payment For Order Flow
It’s also important to talk about payment for order flow in relation to dark pools. It’s enlightening to hear how dark pools and payment for order flow operate from none other than Gary Gensler, the chair of the SEC. Here is what he stated in a video from March 2022. He says, “Our broker transmits our order to what’s generally referred to as a wholesaler in the dark market […]” when a purchase order is put in a brokerage app. We could be perplexed as to why a wholesaler would pay to do business with us.
Our broker must offer us the greatest execution when we purchase or sell stock. We are required to obtain the greatest price that is realistically offered, not only a
Uses for Dark Pool Trades
Dark pools are used for a variety of primary purposes.
1. Mutual Funds, Pensions & Other Sources of Institutional Capital
The one that is perhaps the most obvious is with pensions, mutual funds, and other significant institutional capital sources. They can purchase large blocks of stock at a reduced spread and with less of an influence on market pricing by using dark pools. Saving money eventually helps seniors, owners of mutual funds, and others.
2. Broker-Lead Dark Pools
In broker-led dark pools, where a broker may combine different transactions among its own clients without having to send them out to a stock exchange, there is yet another use. Both parties concerned may avoid paying costs as a result.
3. High-Frequency Trading Shops
High-frequency trading shops are the third use. These funds gain profit by using arbitrage tactics or minor price changes among a variety of stocks. Their trading techniques depend on getting the lowest feasible fees. Dark pools make these methods more practical.
4. Routing Transactions Among Wholesalers
Finally, and perhaps most controversially, dark pools can be used to route transactions between wholesalers in the aforementioned payment-for-order-flow schemes. Although those four applications for dark pools don’t encompass all of their possible uses, they do provide a good overview of what they can do for their clients.
Dark Pool Trading Regulations
Alternative trading platforms sometimes referred to as dark pools, are strictly governed by the SEC. In reality, the SEC has modified its Regulation ATS throughout time to reflect investor criticism and technological advancements.
The SEC has a regularly updated register of all active alternative trading platforms. Operators must submit first operation reports and register as broker-dealers among other procedures in order to be a permitted ATS.
Pros & Cons of Dark Pool Trading
Dark pools, also known as alternative trading platforms, are rigorously regulated by the SEC. Actually, the SEC has changed its Regulation ATS over time to take into account feedback from investors and improvements in technology.
The SEC maintains a list of all current alternative trading platforms that is often updated. Operators must comply with a number of requirements in order to be authorized ATS, including submitting initial operation reports and registering as broker-dealers.
Pros
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- Market Impact: The price of a stock is typically less affected by trading through a dark pool than by making substantial purchases or sales on a public exchange.
- Lower Fees: Trading platforms called dark pools are frequently less expensive than open marketplaces.
- Lower Spreads: Funds frequently benefit from superior transaction execution, such as not having to cover the whole bid/ask spread.
- Provide Competition for the Stock Exchanges: When it comes to public stock exchanges boosting trading costs, dark pools act as a check.
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Cons
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- Lack of Transparency: Despite their shortcomings, public markets provide a transparent order book and trading environment; dark pools don’t.
- Potential Conflicts of Interest: Dark pool deals make it more difficult to identify the possible counterparties, which might provide broker-dealers with a competitive information edge.
- Payment for Order Flow: As mentioned above, as an alternative to paying commissions on supposedly commission-free transactions, certain brokerages may employ dark pools and payment for order flow. Retail dealers may suffer as a result of this.
- Poor Branding: Alternative trading platforms, or dark pools, haven’t done a good job of communicating how their markets work to the general public. Dark pools have a bad image, therefore many investors believe that their existence will impair the stability of the American financial market.
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How To Spot Dark Pool Activity
There isn’t a lot of accurate data on dark pool activity available. This is to be expected considering that a major benefit of dark pools is that they enable institutions to trade in a less transparent environment without being observed by other market players who could try to front-run or otherwise manipulate their deals.
Nevertheless, the Financial Industry Regulatory Authority (FINRA) modified its specifications in 2014 and now expects dark pools to disclose the total number of shares traded in certain equities across all dark pools. This offers some information on if massive block trades are taking place in a certain equity.
Bottom Line
Dark pools are a contentious topic, especially in light of the events surrounding the 2021 meme stock phenomena. The majority of individual investors, though, need not worry about dark pools, in actuality. Dark pools are tightly controlled and watched over by the SEC and primarily serve to save institutional traders modest sums of money and fees.
