As of today, the information and transparency gap between retail and institutional investors has never been tighter. In fact, its nearly paper-thin at this point.
However, a gap of information is still a gap nonetheless.
Your average semi-dedicated retail trader can now easily find out what hedge funds are trading, how much short interest there is within a company, what insiders are trading and more; although that doesn’t exclude the significant effects stemming from this tiny gap.
Dark pools were incepted as a way for enormous blocks of shares to be traded amongst large institutions anonymously.
The idea was for institutions to avoid fluctuating the market price with large significant orders, achieve a consistent stable price in which to trade shares, and prevent competition from scoping out their bids/asks and acting against them.
This may sound like a win-win in theory, but plenty of emerging technologies like high-frequency trading have affected the efficacy of dark pools within a fair market.
Before we get into how dark pools have developed and the ongoing regulatory maintenance they require, let us tell you what they’re all about first.
| 1. | What is a Dark Pool? |
| 2. | Are Dark Pools Legal? |
| 3. | Different Types of Dark Pools |
| 3.1 Broker-Dealer-Owned Dark Pools | |
| 3.2 Agent Broker or Exchange-Owned Dark Pools | |
| 3.3 Electronic Market Makers Dark Pools | |
| 4. | Winners and Losers of Dark Pools – Is the Playing Field Fair? |
| 5. | The Future of Dark Pools |
1. What Is A Dark Pool?
Dark pools certainly live up to their mystifying name in the sense that they are undisclosed and anonymous. However, there’s no drowning or swimming involved.
A regulatory change by the Securities and Exchange Commision (SEC) in 1979 incepted the idea of dark pools. The desire for traders to have lower execution costs and more anonymity is what bred the creation of dark pools.
Dark pools are a private securities exchange where investors, typically large financial institutions, are able to make trades anonymously. They allow investors to engage in an anonymous exchange of large blocks of shares to be traded directly to other buyers without the general public, or anyone for that matter, knowing whom it went to and where. Prices are not displayed on dark pool exchanges.
Generally, institutional investors can use dark pools to trade large blocks to other institutional investors, without having to break it up into small chunks to distribute amongst smaller investors.
When institutional traders moved large blocks of shares before dark pools, the execution costs could often add up, not to mention the order had to be broken up into smaller chunks and often at different prices, drastically affecting the stock price. Plus, every trade had to be disclosed, allowing competitor funds to easily track what their peers were doing.
The 1st actual dark pool, called After Hours Cross, which was built by Instinet, wasn’t created until 1986. Investors were pleased to be able to place incognito orders that were matched once the markets had closed.
According to research conducted by Credit Suisse in 2015, the rising popularity of dark pools came from constant regulatory changes, better trading technology and a decline in volatility within the markets.
3. Are Dark Pools Legal?
Dark pools are definitely legal. Their name comes from the nature of having a total lack of transparency.
It is not easy to trade blocks of shares worth millions of dollars without adversely affecting the market. The share price of a company can be greatly affected when a massive buy order swoops in.
This is because there are likely not buyers for a million shares of a certain stock at one single price. Often, institutional buyers would have to conduct market orders (meaning the price they pay is whatever the best price is available on the market). This means if they wanted to buy 1 million shares of Company ABC at $120/share, they likely would be paying a higher average cost as once the sellers at $120 dry up, the only other sellers that might be offering shares on the market might be at $121, $122, and so forth.
Dark pools allow them to offer $120 million for 1 million shares at $120/share, and leave it at that until another institution or trader wishes to match them and pay $120 million for the 1 million shares at $120/share.
Dark pools serve their own purpose and can avoid excessive market manipulation, but they are sometimes looked poorly upon, especially due to the creation of high-frequency trading (HFT), often done through artificial intelligence (AI).
Because AI powered HFT is lightning fast, it can often track Dark Pool transactions and use that information to benefit the trader, often in a predatory manner. Conflicts of interest by owners of the dark pools and cause some controversy as well.
Despite the growing concern due to new market technological advancement, the purpose of dark pools ultimately lies in avoiding significant market impact with large trades and adverse price changes when executing sizeable orders.
Did you know? In 2010 dark pools made up for 16% of the stock trading volume in the U.S. By 2017, this number jumped from 40%.
To put it bluntly, institutional investors want to trade enormous blocks of shares to other institutional investors, in one transaction, with one price, with no one else taking notice of using available knowledge to their advantage. Ordinary orders are displayed even before they are executed in the form of bids (people wanting to buy) and asks (people wanting to sell.)
Institutional investors have the ability to help price improvement if they engage in dark pool trading at the same price that is the current market price of the stock within the regular exchanges.
For example, if Company ABC has a bid of $119/share, and asks of $121/share, the average market price would be $120, which is what institutions should trade at within dark pools.
Of course, there could be a leak of information regarding Dark Pool transactions and high-frequency traders could be lurking to use this knowledge to front run the market. There are still some issues to address regarding the current state of dark pools, especially with the introduction of payment for order flow, which is the act of brokerages such as Robinhood sending customers’ orders to market makers to execute off-exchange.
Critics argue that these market makers are paying Robinhood for the privilege of executing these retail trades, in the hopes of using this knowledge of what retail traders are doing to profit off of, in what many say is an alleged frontrunning scheme.
Did you know? Front-running is trading stock or any other financial asset by a broker who has inside knowledge of a future transaction that is about to affect its price substantially.
3. Different Types of Dark Pools
There are over 50 dark pools registered with the SEC as of February 2020. This variety of dark pools falls into three different categories.
3.1 Broker-Dealer-Owned Dark Pool
A broker is someone who acts as an agent, and simply buys and sells securities on behalf of someone else, without actually owning the securities. Think of a real estate agent. They facilitate the sale and take a commission for the transaction.
A dealer is an entity who buys and sells securities on behalf of itself. Also referred to as a principal, dealers buy and trade securities with their own inventory as well.
A broker-dealer performs both duties.
Broker-dealers set up dark pools for their clients and in some cases, their own proprietary traders. The pools retrieve their prices from the order flow they already facilitate, which adds to the element of price discovery.
Did you know? Price discovery is the means through which an asset’s price is set by matching buyers and sellers according to a price that both sides find acceptable. It is largely driven by supply and demand.
Examples of some broker-dealer-owned dark pools include
- CrossFinder – Credit Suisse
- Sigma X – Goldman Sachs
- Citi-Match – Citibank
- MS Pool – Morgan Stanley
3.2 Agent Broker or Exchange-Owned Dark Pool
As their name suggests, these dark pools act as agents (or brokers), and not principals (dealers). They never own the securities, but simply facilitate the exchange within the dark pool.
Prices are always derived directly from the exchanges, and calculated by the national best bid and offer (NBBO).
Did you know? The NBBO is calculated and disseminated by Security Information Processors (SIP) as part of the National Market System Plan (NMSP), which is used to process security prices. There are two SIPs responsible for this task. The Consolidated Quotation System (CQS) gives the NBBO for securities listed on the New York Stock Exchange (NYSE), NY-ARCA, and NY-MKT, whereas the Unlisted Trading Privileges (UTP) Quote Data Feed gives the NBBO for securities listed on the Nasdaq.
Examples of agency broker dark pools include:
- Instinet
- Liquidnet
- ITG Posit
Examples of exchange-owned dark pools include:
- BATS Trading
- NYSE Euronext
3.3 Electronic Market Makers Dark Pools
This category of dark pools are offered by independent operators. These dark pools act as principals for their own accounts. The quotes for electronic market maker dark pools are void of NBBO calculation, bringing price discovery into the scenario.
4. Winners and Losers of Dark Pools – Is the Playing Field Fair?
Both retail and institutional investors have had their share of winning and losing during the existence of dark pools.
Despite retail investors historically benefit from large institutions using dark pools to prevent them from adversely affecting the market price of stocks, there have been some developments within the realm of the market that bring a dose of controversy into the mix.
Institutions first rejoiced in the idea of dark pools to avoid adverse price changes in the midst of them buying or selling a giant block of shares. They were especially pleased with their decision once HFT came into play within the traditional exchanges. Many institutions looked at HFT as a predatory algorithm that aimed to detect large orders within the displayed markets and trade against them; a banned method known as front-running.
A problem arose within the dark pools. Liquidity became scarce as the number of institutions using dark pools increased. Anytime a dark pool had heavy institutional interest on either the buy side or sell side of a stock, finding an entity to buy or sell the other side of these extra-large trades became increasingly difficult.
As a result, HFT became accepted within many dark pools, which ended up resulting in the same front-running-like activity the institutions wanted to avoid.
Front-running unfortunately became an issue within dark pools, to the point where many operators were handed fines, and in some cases lawsuits. Crooked traders could detect when another trader is going to buy a stock. They would then swiftly buy the stock before you are able to, and sell it to you at a higher price.
Amid the GameStop, Inc. ($GME) and Robinhood fiasco earlier in the year, you may have heard the term payment for order flow (PFOF).
This involves large market making firms paying brokers such as Robinhood for the privilege of executing trades for them.
The market makers aim to get the customer the best price, but will often collect a difference between the price that the buyer is willing to pay and the seller is willing to accept. This creates an income stream for firms such as Robinhood.
Putting this method into context, a market maker could take on the duty of filling a buy order of a stock at $5.05/share. By inspecting both the dark pool and the traditional exchange, the market maker may find that there are sellers for $5.02. They would then purchase this block of shares, and likely sell it right to you (the Robinhood customer) for $5.04; not only claiming to get you the best price possible, but also pocketing the $0.02/share difference.
While this may seem trivial, the $0.02 spread equates to $20,000 on a block of 1 million shares. Robinhood facilitates millions of trades per day; it manages 18 million accounts and over US$80 billion. No wonder these firms pay the app to execute trades. The arbitrage is bountiful.
Such practices are causing controversy around the company’s methods of generating revenue. Brokerages earnings from PFOF are incentivized more by maximizing profits rather than providing customers the best prices possible, leading to a conflict of interest.
Retail investing can also suffer further with the use of dark pools by mutual funds and pension funds. The pricing and cost advantages that these types of funds receive within dark pools can ultimately benefit them; at the cost of the retail investor of course. Scooping up the difference between a cheaper block of shares than the one your fund purchases is a classic example of front-running.
5. The Future of Dark Pools
Regulators, who have naturally viewed dark pools as suspicious, have been paying more attention as HFT continues to cause controversy in the form of retail investors being taken advantage of.
Perhaps the most significant effort to curb this problem is the “trade-at” rule, which requires all brokers to send their clients’ trade orders to exchanges, and not to dark pools. The only exception to this would be if the dark pool could be executed at a better price than the exchange.
The long-term sustainability of dark pools could be compromised due to this loss of volume; however, many argue it is for the greater good of the stock market.
Gary Gensler, chairman of the SEC has seriously considered banning the practice of PFOF. Companies like Virtu Financial ($VIRT) and Robinhood ($HOOD) would be dramatically affected as their revenue depends on PFOF.
According to Gensler, half the trading volume within the U.S. market is happening from exchanges, by dark pool “wholesalers.”
Retail heavy stocks are especially seeing increasing volume happening within dark pools, which can be as high as 70%. While this is good for firms because of increased dark pool liquidity, it can lead to disadvantages to the average retail investor.
Ideally, Gensler stresses that internalized wholesale exchanges should be saved for institutions, and the alarming number of smaller retail orders being facilitated within these dark pools can be problematic.
Additionally, further transparency on dark pools needs to be addressed due to risky and potentially predatory trading strategies such as short positions, derivatives, and naked shorting.
Retail trades started to be executed on dark pools to help liquidity for institutions, while not holding any real benefit for retail. Now the overload of retail trades on dark pools is tipping the scale in the institutions favour.
As regulators continue to inspect this shadowy side of the market, we can expect better transparency, stronger price improvement for small orders, less PFOF-based business models, and re-routing of retail orders back to traditional exchanges.
The SEC aims to have the U.S. catch up to Canada as far as regulation and transparency, not to mention the executing costs for traditional markets in the U.S. have been jacked up in comparison to up north due to the lower supply of exchange-facilitated trades.
What direction do you think the market should go as far as regulating dark pools?