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A Guide to Dark Pools

Dark pools have been a heated topic of debate amongst investors in recent years. The proliferation of quants and supercomputers has resulted in massive blocks of liquidity being traded by high-frequency bots, manipulating the markets and significantly dropping intraday holding times. Due to their increasing role in today’s markets, let’s take a look at dark pools and help you navigate their murky waters.

What is a Dark Pool?

A dark pool is a justifiably ominous term used to describe the massive trading volume created by large institutional orders that are not traded on the central exchanges and unavailable to the general investing public.

Why Dark Pools Exist

While dark pools have existed since the 1980s, the recent surge in non-exchange trading, which now accounts for nearly 20 percent of all US trading volume, has made them hot topics of discussion and concern in recent years.

The rapid rise of dark pools correlates with a direct need for large institutional investors to buy or sell large blocks of stock as quickly, seamlessly, and discreetly as possible without disrupting the markets and whipsawing the price of companies every minute of every trading day.

Of course, dark pools provide a number of benefits for institutional investors as well. For instance, the lack of transparency in dark pools allows them to gain better realized prices for stocks than they would if the transactions took place on the public exchanges. Since dark pools are essentially private forums dedicated to large institutional investors, institutional sellers are also more likely to quickly find buyers for a full share block.

Types of Dark Pools

Currently, there are 45 dark pools operating in the US alone, each of which falls into one of the following three categories:

• Electronic market makers – These dark pools are provided by independent operators who act as principals for their own accounts. Unlike exchange-owned or agency broker dark pools, electronic market makers do not calculate their prices from the National Best Bid and Offer, so there is an element of price discovery.

• Exchange-owned or agency broker – Acting more like agents than principals, these dark pools operate with prices derived from exchanges. Therefore, exchange-owned or agency broker dark pools lack any element of price discovery. Some notable exchange-owned or agency broker dark pools include Liquidnet, Instinet, ITG Posit, and those provided by NYSE Euronext.

• Broker-dealer owned – This type of dark pool is established by large brokers and dealers for clients and proprietary traders. With prices derived from order flow, these dark pools all share an element of price discovery. Some notable broker-dealer owned dark pools include Morgan Stanley’s MS Pool, Goldman Sachs’ Sigma X, Credit Suisse’s CrossFinder, and Citi’s Citi Match.

The Future of Dark Pools

The lack of transparency present in dark pools has drawn criticism and caused suspicion amongst investors and regulators for years, but the recent HFT controversy may result in renewed regulation efforts to help the exchanges regain market share of the markets.

Currently, one of the measures being mulled over is an SEC pilot proposal that would implement a rule requiring brokerages to route client trades away from dark pools and to the exchanges, unless trades can be executed at significantly better prices than those available on the public market. Needless to say, this rule alone could seriously challenge the viability of dark pools in the future.

Bottom Line

Pension funds, mutual funds, and other buy-side institutions utilize dark pools for their cost and pricing advantages. Unfortunately, the lack of transparency associated with dark pools has made them susceptible to predatory trading by HFT firms and conflicts of interest amongst their owners. With increased scrutiny in recent years, many feel it is only a matter of time until dark pools lose their appeal and influence on the markets.

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