Dark Pool Trading
A dark pool is an alternative market where institutions can buy and sell stock with certain differences from trades on traditional public stock markets.
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What Is a Dark Pool?
A dark pool is a private market where institutions can trade securities without having to route their orders to a public stock exchange. According to an SEC statement, off-market trading began in the late 1960s. However, what are known as alternative trading systems (ATS) rose to prominence in 2005 when the SEC enacted Regulation NMS which created a clearer regulatory framework for off-exchange trading.
In popular language, these forums for trading are often referred to as dark pools. Many investors have a negative perception of dark pools, and in some cases, that's understandable. However, at its core, a dark pool is simply a private exchange where investors can trade shares without having those transactions show up on a major stock exchange.
How Dark Pool Trading Works
In essence, these dark pools function like normal stock exchanges, in that they bring buyers and sellers together. However, they offer some advantages for institutions. For one, bids and asks aren't widely quoted, as they are on public exchanges, making it easier for large mutual or hedge funds to transact in big blocks of stock without unnerving the market.
If a mutual fund puts a 5 million share sell order on the Nasdaq, the price of the security would likely drop sharply as other traders raced to sell first. Putting that block of stock for sale on a dark pool avoids notifying other market participants. The results of dark pool trades aren't immediately posted outside of the pool either, so heavy volume in a dark pool won't scare other market participants.
Dark pools are also useful for high-frequency trading shops. These firms operate strategies which typically trade thousands of times per day, and thus benefit from minor savings in price and fees versus routing orders through a public stock exchange.
Dark Pools & Payment For Order Flow
For another point, it's worth discussing payment for order flow, and how it relates to dark pools. It's instructive to hear from no less than the chair of the SEC, Gary Gensler, to describe how dark pools and payment for order flow works. Here's what he said in a March 2022 video. His quote describes what happens when a buy order is placed in a brokerage app:
"Our broker sends our order to what's often called a wholesaler in the dark market [...] We may wonder why a wholesaler is willing to pay to trade with us.
When we buy or sell a stock, our broker is required to provide us with best execution. We're supposed to get the best price reasonably available, not just a good price. If one of our market orders to buy stock were routed to an exchange, the exchange would need to match our order with the lowest price available on that exchange. That's called competition [...]
But if the order instead is routed to a wholesaler who has agreed to pay for it, the order is not going to an exchange, and is not necessarily receiving the benefit of broader competition. The wholesaler might sell to us at a price better than the best price shown to the public on the exchange but not necessarily the best price available. That's because so much of the market is in the dark pools, or with the wholesalers in dark, not necessarily competing order by order."
Gensler went on to warn that "free commissions" aren't necessarily free and that brokerages may be encouraging to customers to trade more frequently in order to earn more payments for order flow from these dark pool wholesalers. Note, however, that Gensler said nothing about short selling, market manipulation, or other such things that are often popularly associated with dark pools.
To summarize, one use of dark pools is to facilitate brokerages avoiding the national best bid/best offer restrictions and generating an alternative revenue stream to commissions. To the extent that dark pools create issues for retail traders, it is likely to be through brokerages which aggressively benefit from payment for order flow.
Uses for Dark Pool Trades
There are various categories of primary usages for dark pools.
1. Mutual Funds, Pensions & Other Sources of Institutional Capital
Perhaps the clearest one is with mutual funds, pensions, and other large sources of institutional capital. By using dark pools, they can buy big blocks of stock at a lower spread and with less impact on market prices. This, in turn, saves money that ultimately benefits pensioners, mutual fund owners and so on.
2. Broker-Lead Dark Pools
Another use is in broker-led dark pools, where a broker can group various transactions among its own clients without having to route them out to a stock exchange. This can save fees for both parties involved.
3. High-Frequency Trading Shops
A third usage is for high-frequency trading shops. These funds make money capitalizing on arbitrage strategies or tiny price movements across many different equities. Their strategies rely on trading at the absolute lowest fees possible. Dark pools help make these approaches more feasible.
4. Routing Transactions Among Wholesalers
Finally, and most controversially, dark pools can be used for routing transactions among wholesalers in payment-for-order-flow systems as described above. That's not all the potential uses of dark pools, but those four cover a wide range of what dark pools can accomplish for their customers.
Dark Pool Trading Regulations
The SEC closely regulates alternative trading systems, or what are colloquially known as dark pools. In fact, the SEC has updated its Regulation ATS over the years to adjust to investor feedback and advances in technology.
The SEC maintains a registry of all operational alternative trading systems, which it updates monthly. To be an approved ATS, an operator must register as a broker-dealer and file initial operation reports, among other requirements.
Pros & Cons of Dark Pool Trading
Dark pools offer some obvious advantages for customers, which is largely why they've become so popular over the past 15 years. However, there are some real drawbacks to the use of dark pools as well.
Pros
Market Impact: Trading through a dark pool generally causes less impact on a stock price than buying or selling large amounts on a public exchange.
Lower Fees: Dark pools are often cheaper trading venues than the public markets.
Lower Spreads: Funds can often achieve better execution on their trades, such as not paying the full bid/ask spread.
- Provide Competition for the Stock Exchanges: Dark pools serve as a check on public stock markets when it comes to raising trading fees.
Cons
Lack of Transparency: Public markets, for all their drawbacks, offer a clear and visible order book and trading environment; dark pools have less transparency.
Potential Conflicts of Interest: It's harder to know who the counterparties may be on dark pool trades, potentially allowing broker-dealers to get an information advantage in transactions.
Payment for Order Flow: As described above, some brokerages may use dark pools and payment for order flow as an alternative way of getting paid on purportedly commission-free trades. This may be a disadvantage to retail traders.
- Poor Branding: Dark pools, or rather alternative trading systems, have not done a good job of explaining their market function to the public. Due to their poor reputation, many investors associate dark pools with a weakening of American financial market stability.
How To Spot Dark Pool Activity
There's not a whole lot of reliable dark pool activity information out there. This is as expected, given that a big feature of dark pools is that they allow institutions to trade in a more opaque setting away from the scrutiny of market participants that would try to front-run or otherwise game their trades.
That said, the
Financial Industry Regulatory Authority (FINRA) changed its requirements in 2014, making dark pools report the total amount of shares traded in individual stocks across dark pools. This provides some insight into whether big block transactions are happening in an individual equity.Bottom Line
Dark pools are a controversial subject, particularly after the events of the 2021 meme stock phenomenon. However, the truth is that most individual investors have nothing to worry about with dark pools. Dark pools primarily exist to save small amounts of money and fees for institutional traders, and they are regulated and monitored closely by the SEC.
FAQ
No, dark pool trading is not illegal by any means. The SEC closely regulates dark pools, or what are more formally known as alternative trading systems. There can be individual illegal transactions that may occur in dark pools, just as there can be on a regular stock exchange. However, the practice of trading in dark pools itself is legitimate.
In general, dark pools are designed to be used by institutions, market makers, and other such professional traders. However, some retail brokerages do allow traders to select which exchange they want to route their order through. These options may include some alternative trading systems in additional to the usual stock exchanges.
In general, the difference between execution at a stock exchange and in a dark pool would be tiny for the average investor. Saving fractions of a penny per share on trades matters a lot to high-frequency traders and funds moving millions of shares of stock around, but it shouldn't make much impact to the average long-term investor.
This article was written by
Ian Bezek is a former hedge fund analyst at Kerrisdale Capital. He has spent the decade living in Latin America, doing the boots-on-the ground research for investors interested in markets such as Mexico, Colombia, and Chile. He also specializes in high-quality compounders and growth stocks at reasonable prices in the US and other developed markets.
Ian leads the investing group Learn more .Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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Comments (14)
Rampant manipulation and short and distort campaigns are blatantly operating
Junior bio technology companies are often targeted in attacks to attempt to suppress their ability to get approval for drugs which may compete with those being supplied by big pharmaceutical firms .
I site the case of Cassava Science
and their pioneering drug for Alzheimer’s.
I see no evidence of any effective SEC investigation of the bad actors behind this dreadful series of short and distort attacks on the company.
Dark pools have been used extensively to short the stock in tandem with negative press articles by so called expert scientists and analysis.
The SEC have allowed these sustained attacks over a significant period with no preventative action.
See Remi Barbers letter to the Science Editor of the New Yorker.