Dark Pool: Definition, Use, and Examples

Dark Pool Definition
Dark Pool Definition, Use, and Examples

Dark pools, also known as Alternative Trading Systems (ATS), are regulated private markets for trading securities. In a dark pool trading market, traders execute buy and sell bids without revealing the price or quantity of shares involved.

Dark pool transactions are conducted “over the counter.” This indicates that equities are exchanged directly between the buyer and seller, albeit frequently with the assistance of a broker. Instead of depending on centralized pricing, as is the case with public exchanges, over-the-counter traders negotiate prices privately.

Dark Pools are trading platforms similar to any other normal public exchange. The only difference is that the dark pools lack transparency to avoid any kind of influence on the prices in the market. 

Dark pools are widespread. In the 1980s, dark pools were formed when investment firms wanted a place to trade enormous quantities of financial assets sans disclosing their identities.

Dark pools permitted the trade of huge transactions without causing a crisis, therefore, financial authorities had no objections. When orders are put in a dark pool, huge price volatility caused by a large transaction in a public exchange is mitigated.

What is a Dark Pool?

Dark pools are trading platform which is privately organized. Dark pools allow institutional investors to trade large amounts of shares without getting any kind of media attention. A dark pool is also referred to as “dark liquidity”  because of the anonymity of trade that it offers. It is beneficial for hedge funds and big investors, as they don’t want to reveal their next move in the market.

Dark pool trading is generally used for block trades. Block trade is the exchange of shares in large volumes, which is large enough to have some effect on share prices.

The other reason why the dark pool is so common among institutional investors is to avoid front-running investors. Front running is a practice in which an investor takes an early position before a large trade to make maximum profit. Dark pools reveal the trade only after these trades are completed.

How does Dark Pool work?

Dark pools work just like other stock exchanges, having the same purpose of bringing buyers and sellers together. The only difference is that, unlike public exchanges, the deals are never disclosed, making it easier for hedge funds and big investors to trade easily without influencing prices. Many dark pools are already operating in the United States Of America, like Goldman Sachs’ Sigma X dark pool and Morgan Stanley’s MS Pool. The SEC regulates these dark pool systems (Securities and Exchange Commission).

Let us take an example to understand why dark pools are important. Let us assume a noteworthy institutional investor is trying to pace a large sell order. The reason need not be investment-related and could even be personal. But regardless, a large order from an institutional investor could create volatility. But when the same trade happens through a dark pool, there is no official book entry for this. Hence, it won’t create volatility. This is one reason why authorities are not entirely against dark pools.

What is the use of Dark Pools?

Dark pools are highly useful because of which their number has been increasing rapidly over the years.

use of Dark Pools
Use of Dark Pools

Dark pools are highly useful for big investors in the following ways:

  1. Investors or hedge funds acquire a significant percentage of the company’s equity without getting noticed, even if they are trading high volumes of shares.
  2. Usually, the traders want to hide their identity, in case they are well-known investors. Their identity, if revealed, might indicate their intentions about the company. So to avoid all the trouble, dark pools are preferred over normal stock exchanges.
  3. These platforms use a high-frequency trading mechanism, which allows them to get more liquidity. High-Frequency trading is a trading mechanism that uses computers to perform a large number of trades in a short duration of time. It is because of the high liquidity mechanism that traders make huge profits in very less time.

What are Dark Pool examples?

Just because of its name, “dark” pools are considered to be unlawful but in actuality, these trading platforms are under the regulations of the SEC. There are various kinds of dark pools operating in the market, following are some examples:

  1. Independent companies: Dark pools owned by individual companies. These dark pools are owned privately.

Examples: Chi-X Global, NYFIX Millennium, etc.

  1. Broker-owned dark pools: In these kinds of dark pools, brokers of one client interact with brokers of another client 

Examples: JP Morgan – JPMX, Barclays Capital – LX Liquidity Cross, etc.

  1. Public exchanges: some public exchanges help their clients to get the benefits of anonymity by introducing dark pool platforms.

Examples: NYSE Euronext, BATS Trading, etc.

How to trade using Dark Pool?

Dark Pools are mostly similar to normal stock exchanges with a simple difference in anonymity. As per the institute of CFA, dark pools account for about 10% of the total trade volume.

Various banks are involved in the process of dark pool trading, like  UBS, Goldman Sachs, Deutsche Bank, etc. Rates for dark pools change as per the demand and supply relationships. The price used during the transactions is determined by the average between the highest bid and lowest ask price.

The transaction is completed only after the dark pools find both seller and buyer for a set of securities, during the process, nothing is disclosed. These dark pools also do not allow the buyer to check for securities’ availability and price before the transactions.

The anonymity allows the dark pool to control the trade without information getting leaked, which might have influenced the price. The lower transaction costs, as compared to normal exchanges, are yet another benefit.

Which is the best Dark Pool?

Although many dark pools are available in the market, among them, the best one is JP Morgan – JPMX. J.P. Morgan & Co. is a commercial and investment banking institution established by J. P. Morgan in the year 1871. Currently, it is the largest banking institution in the world. Two alternate trading platforms are available under the JPMS(a subsidiary of JP Morgan & Chase), including JPM-X and JPB-X.

The biggest advantage is that you control the order flow types with which you interact, as JP Morgan’s dark pool, with the help of its tiered structure, supports selective crossing.

How does Dark Pool earn money?

Dark pools earn money based on trades they complete successfully. More than 40% of institutional trades take place under these dark pools. Institutional investors pay a particular commission after the trade is completed. These commission rates are generally lower when compared to normal stock exchanges. 

 Can anyone trade Dark Pool?

Yes, anyone can trade in the dark pool. Many traders have a negative perception of dark pools. The term “dark” is very often confused with illegal activities, but in actuality, dark pools are monitored and regulated by the respective government agencies. 

Generally, dark pools are not available to public investors, but nowadays, these dark pools are becoming more and more accessible.

Yes, Dark pools are for everyone, anyone who is interested in buying or selling bulk amounts of their shares anonymously does this with the help of dark pools. But generally, these pools are used by big investors or hedge funds because the number of shares they are buying might influence the price of the shares. Retail investors usually don’t cause a significant change in market prices.

Is Dark Pool illegal?

Yes, dark pools are completely legal as they are regulated by government agencies. So there is nothing illegal about trading through the dark pools. But there are a set of investors who feel that the lack of transparency in the trade gives an unfair advantage to institutional investors. High-volume and high-frequency traders take advantage of the dark pool trades for the same reason. Hence, Dark pools are completely legal, and anyone interested can buy shares through these pools.

Is Dark Pool allowed in trading stocks?

Yes, a dark pool is allowed for trading stocks. A huge amount of block trading takes place through these dark pools. For example, in the US stock market, the amount of stock trading through dark pools has increased rapidly, in 2010, only 16% of the US stocks were traded through these pools. But now, more than 40% of the stocks are traded through dark pools in stock market.

These dark pools have become popular among big investors over time. There are dark pools for other assets also, like cryptocurrencies.

Does Dark Pool affect stock prices?

No, the dark pool trades do not affect the stock prices because the whole process is completed anonymously, unlike public exchanges in which the news might get leaked through various media platforms, which would eventually influence the price. The change in price causes unwanted loss. For example, if someone is planning to buy 1 lakh shares of a particular company, if done through public exchanges, inflate the price, because of which the person will have to pay more than the original price. The problem is solved with the help of dark pools, as the information about the deal is only revealed after the transaction is successfully done.

Does NYSE allow Dark pools?

Yes. As per NYSE(New York Stock Exchange), the dark pools are completely legal and operate independently under the regulations of the concerned government agencies. As per NYSE, the dark pools are not subjected to harsh restrictions like the licensed stock exchanges.

But, As per New York Stock Exchange, transparent exchanges are even more important, and so NYSE continues to prioritize them over the other alternative trading platforms (like dark pools).

Does the SEC regulate Dark Pool Trading?

Yes, the SEC regular dark pool trading. SEC stands for Securities and Exchange Commission, it is an independent council under the US government which is responsible for creating laws related to securities. The main aim of the SEC is to maintain the market fair and efficient for all investors.

To ensure that the dark pools work efficiently without suppressing the rights of small investors, SEC ensures that no unfair practices are taking place in dark pools.

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