An introduction to dark pools - should you be afraid of the dark?
A dark pool is a private, off-exchange venue for stock trading, not accessible by the general public, and where trade details are confidential. The proportion of trades conducted within such forums has surged in recent years, with a significant portion of all stock trading now taking place in such forums.
Originally arising to facilitate block trading by institutional investors who wished to minimize their market impact and lower their transaction costs, access to dark pools of liquidity are mostly through “crossing networks” or by private contractual agreement.
The lack of transparency and confidential nature of dark pools can also create weaknesses, such as potential conflicts of interest or potential front-running from high-frequency traders (where they are allowed to trade). The opaque nature of such pools could also mean that prices do not reflect the “real” market.
There are three main types of dark pool:
- Those owned by exchanges or agency brokers (e.g. Instinet, Liquidnet, ITG Posit or offered by Euronext). The dark pool acts as an agent, with prices derived from the public exchange.
- Those owned by broker-dealers (e.g. as operated by Goldman Sachs, Morgan Stanley, Credit Suisse and others). Set up for use by clients of the broker (and sometimes the bank’s own proprietary traders).
- Independent electronic markets (e.g. as operated by Knight or Getco, who act on a principal basis). Prices are not derived externally, but are agreed between the counterparties.
We have curated some excellent academic and practitioner papers on the subject of dark pools. Here is a small selection:
What are dark pools? How do they work? Who uses them, and how? This paper sheds light on the murky world of dark pools explaining the differences for investors trading in a dark pool versus trading on a listed platform. It poses the question: should you be afraid of the dark?
This report from the US Congressional Research Service examines the factors that led to the rise of dark pools; the potential benefits and costs of such trading; and recent regulatory developments.
This academic paper examines the impact of adding a dark pool alongside an existing limit-order book.