Trading is something we do daily, such as trading a book in exchange for money. But have you ever done Dark Pool Trading? Most of the people may not even have the basic information about this type of trading.
Dark pools are private hubs or forums for the trading of financial securities. Unlike public exchange markets, these networks are not transparent. Originally started for block trading, dark pools have now become quite common.
Read ahead to know more about both Block Trading and Dark Pool Trading.
Block Trading and Dark Pool Trading
Block Trading refers to the exchange of a large number of securities. Such a high-level trade may have a great impact on the goodwill of the company whose shares are being sold. Moreover, by the time a potential buyer or seller is found, the prices of the securities may have considerably changed.
This type of trading is relatively more challenging, as it is hard to find a buyer or seller to trade a notably large amount. With the introduction of Dark Pools, block trading became easier. This is because a dark pool mainly consists of buyers and sellers looking for high-level transactions.
Some of the institutional investors did not want to exchange publicly or want their trade to expose to front running investors. Front running investors would invest in a security exchange (buy or sell) right before you invest. They did this to exchange (buy or sell) right after, at a higher price. This way, the front running investor gets the benefit of the price movement before the block trade completes.
What is the Purpose of Dark Pool Trading?
Initially used by institutional investors, these private networks have now become as popular as public stock exchanges. Also known as Alternative Trading Systems (ATS), Dark Pools are legal exchange markets that are regulated by the Stock Exchange Commission (SEC). These markets are a modern alternative to the traditional stock exchange markets.
Dark Pool Trading is also known as over-the-counter (OTC) trading. What’s more? The traders that utilize Dark Pool Trading stay ahead of the other traders in the exchange market. With the passing time, this private exchange market has become even more popular than the traditional exchange like the New York Stock Exchange.
The purpose of Dark Pools is to get the best bid and offer price. How is that possible? Dark Pools work to match the ideals set by the National Best Bid and Offer (NBBO) regulation. The United States SEC sets the best current bid and offer prices for a security exchange.
While trading in the public stock exchange, the seller might not get the desired prices. By the time a buyer is found, there would be a devaluation in the securities. Dark Pools allow the sellers to conduct the trade at their set prices without any public intervention. This network also helps in cutting the commission charges to be paid to the stock exchange.
Though dark pools are regulated by the SEC, it was not always like this. Read on to know how dark pools evolved.
Dark Pool Trading—Evolution and Present-Day Situation
History
Dark Pools, earlier known as upstairs trading, started in the year 1979 with the enactment of the rule 19c-3, established on the 26th of April. It states that for a security to be traded in an off-exchange market, it has to appear on the stock exchange list.
During that time, it only made for a small portion of the total trading. These forums originally came into action because institutional investors wanted to conduct block trading outside the stock exchange. Trading publicly leads to fluctuation (often devaluation) in the market prices, which made the investors establish an off-exchange market. Apart from preventing price movements, dark pools were started to keep the trading private.
The first dark pool trading center came into existence in 1986, when a company named Instinet started ‘After Hours Cross.’ As the name states, this forum worked based on stock exchange prices that were prevailing once it was closed, i.e., at 6:30 p.m. The orders made during the day were settled at the closing time by an algorithm connecting the buyers and sellers. If an order was pending on a particular day, it was kept private, which was only shared among some investor groups.
Following the success of After Hours Cross, ITG established a venue called POSIT. This venue was started in the year 1987 and worked on a different set of principles. Here, the exchange prices were set according to the midpoint price of NBBO. This practice became highly popular among investors giving rise to several other dark pools in the 1980s and 1990s. However, it was only in 1998 that the SEC started regulating the activities of Dark Pool Trading.
Present-Day
Now being a legalized exchange market, this private hub accounts for over 40% of the total exchange of the U.S. What started as a network of trading for large institutional investors has turned into a global trading platform. It is no more restricted to block trading but has spread out to take several other forms.
This hub is utilized not only by investors but also by banks and brokers. These institutions have created their dark pools to match their clients. The middle entities are promoting these networks more and more.
They encourage their clientele to use dark pools for trading since these private hub does not require extra charges. Moreover, the prices offered here are better than those in the stock exchange, since it works based on NBBO prices. Stock exchange requires a commission for exchanging securities and does not depend on NBBO for exchange rates.
There are also entities like JP Morgan Bank that trade themselves in the dark pool to earn profits. This is just an example. There are many more organizations trading in the dark pool. The next section talks about the various categories of private hubs in detail.
Types of Dark Pool Trading
There are over 50 dark pools currently registered with the SEC. Every dark pool falls under one of the following categories, based on the trading venue provider. Although every dark pool has a common agenda of providing private trading opportunities, each of them run on different principles. Let’s know them in detail.
Independent Dark Pool Trading
As the name states, these dark pools are run by individual companies or firms. Some examples of independent providers are Smartpool, ITG, Getco & Knight, Instinet. These providers offer lower transaction costs to traders.
If any extra charge arises due to less liquidity, these providers lower those costs. It becomes a reason for traders to trust these institutions. Another point to note is that the transaction prices in independent dark pools do not depend on NBBO. Here, the price is calculated by ‘price discovery.’
Price Discovery is a mid-point or spot price on which both—the buyer and the seller agree to trade securities.
Broker-Dealer Based Dark Pool Trading
Brokers or intermediaries run Broker-Dealer based dark pools. These brokers are mainly investment banks that encourage their clients to trade in dark pools. These dark pools offer to provide better prices set by the NBBO to their traders. Moreover, these institutions often involve their proprietary traders (a firm that trades for direct profit instead of middle-men commission).
Examples of broker-dealer dark pools are CrossFinder by Credit Suisse, MS Pool by Morgan Stanley, Citi-Cross by Citibank.
Exchange Based Dark Pool Trading
Stock exchanges own these dark pools. They provide a platform for traders who do not want to trade securities in the stock markets. In these forums, the prices are determined based on NBBO prices.
Some famous exchange-owned dark pools are Euronext—owned by NYSE, ISE, and BATS.
How Does Dark Pool Trading Take Place?
Once a block trade starts, the digital programs of Dark Pool find the investors who want to buy the securities. Since the process is digitalized and consists of algorithms, it does not take a lot of time. Moreover, the forum is mainly for block trades, which is why potential investors can be found relatively sooner. The interested buyer and seller are then connected to complete the exchange.
Until the trade is complete, it is kept anonymous. The lack of transparency in trades helps to reduce front running, which further prevents devaluation of the securities.
This would not have been possible in public security exchanges. For example, company R Inc. plans to sell 5,00,000 shares to an investor in a stock exchange. Firstly, it would take a few days to find an interested investor. Secondly, if the company plans to sell 1 million shares each to five investors, it would take some time.
In both cases, there would be a considerable decline in the share price. Besides, there are chances of front running investors taking advantage of the situation as well. Not to forget, it would impact the company’s goodwill.
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What Else Should You Know About Dark Pool Trading?
Since it is an upcoming concept, it is essential to have as much information about dark pools as possible. Here are some more facts about dark pools that will expand your knowledge about this private trading markets.
Dark Pool Trading Depend Upon Stock Markets
Without stock market exchange rates, dark pools cannot perform their activities. As you may have read earlier in this text, these trading hubs depend on NBBO for an exchange rate. But where does NBBO get the prices from?
The highest price that a trader is ready to buy and the lowest price at which another trader is ready to sell makes for the best bid and best offer, respectively. These bids and offers are based on the prevailing price in the stock exchange. This is how the SEC sets NBBO prices.
Dark Pool Trading and HFT
With the invention of large digital programs, several traders got into practicing High-Frequency Trading. When an investor intends to sell a large number of stocks in a public stock exchange, high-frequency traders take advantage of it. They go ahead and trade that security to gain from price improvements.
Due to the algorithms, the trading speed is very high. Before an investor buys the security, high-frequency traders have already traded it multiple times within a few seconds. As a result, the security’s price has deteriorated.
Due to the increased HFT practices in stock exchanges, dark pools have grown with time. Large investors wanted to protect their trade from high-frequency traders. However, dark pools only had big institutional traders and did not have enough matches at the other end of the exchange. That is why several dark pools let in high-frequency traders to satisfy the demand. As a result, HFT has increased a lot in dark pools too.
Everyone can Trade in a Dark Pool
Initially, dark pools were set up for the trade to occur between big institutions. Here, large buyers and sellers could trade without the intervention of other investors that caused a change in prices. However, it is not the case anymore.
With only the large institutions in play, the pools did not have enough liquidity. The number of buyers and sellers were not balanced, which is why dark pools allowed small traders to enter.
Benefits and Downsides of Dark Pool Trading
Benefits
By now, you must be aware of some of the advantages that dark pool trading has over stock market trading. If done right, dark pool trading may turn out to be quite profitable.
Desired prices: The biggest benefit of dark pools is that here there is no intervention in prices. Since the trades are kept private, other traders cannot take advantage of trade, such as front running. As a result, there is no devaluation of securities, and the traders can get the desired prices.
Higher Liquidity: Since HFT has been increasing in dark pools, it is also affecting the efficiency of this market. Now there are no pending trades as high-frequency traders have elevated the number of trades. They have filled the gap between the demand and supply side of an exchange. This improves the liquidity levels of dark pools.
Low Commission Fee: As opposed to the stock exchange, traders in dark pools do not have to pay a fee to the stock exchanges. Even if required, some dark pools charge low transaction fees from the traders. This is because dark pools do not have to pay exchange fees.
Anonymous trading: In dark pools, trades are private until completed. This facilitates the smooth flow of large trades, without the knowledge of the public. Unlike stock exchange trades, dark pool trading does not have to face change in prices.
Downsides
Smooth functionality and credibility of dark pools have been debatable topics from the time of its origin. Some finance professionals call it unfair for the participants; others are worried about its impact on the overall securities trading.
Lack of Transparency: Though an advantage, this may also be one of the downsides for a dark pool trader. Due to anonymity, the trader will not be aware of the right price of the securities. The pool participant would not be sure whether the price he got was the best price possible or not.
Despite the tight regulation of the SEC, some dark pools may get into unfair practices. These may be manipulations of prices and investment frauds.
Impact on Exchange Markets: Since the evolution of the dark pool, it is on the road to expansion. Due to the benefits of dark pool trading, more traders are seeking to invest privately than publicly. However, this is causing the liquidity to decrease in the stock exchange market.
Low liquidity leads to a higher bid-ask spread. As a result, the transaction cost in the stock exchange is on the increasing spree, causing a decrease in market efficiency.
Front-running: Although dark pools are known to be safe from front running, it is not completely correct. Some HFTs are looking for opportunities to invest as soon as trade starts. They take advantage of the client’s orders by breaching the whole concept of ‘private trading.’
With time, SEC is regulating the dark pools even more closely. Several dark pools have been penalized by the SEC for conducting fraudulent and misleading activities. Broker-dealer based dark pools like Barclays is an example of misleading investors. Barclays Plc, along with Credit Suisse AG, paid a total of $154 as a fine to the SEC for unethical activities (Bloomberg).
Things to Remember About Dark Pool Trading
- Dark pools are NOT transparent
- SEC regulates dark pools
- Dark Pools are more popular than the stock exchange
- There are various types of dark pools
- Banks and brokers promote dark pools.
Final Thoughts
The fact whether dark pools are beneficial or not is highly debatable. Some finance trading professionals think that private trading is better than the public stock exchange. They believe that in dark pools, the big investors’ interest is being catered too. At the same time, other scholars consider dark pool trading to promote conflicts of interest and HFT practices.
Irrespective of the above, dark pool trading is on the rise and is here to prevail. It occupies a significant portion of the total securities exchange. Though dark pools are regulated by the SEC, investors may not get the best trade prices. Moreover, more dark pools are making way for more and more HFTs.