Dark pools are parallel, and largely opaque, institutional trading markets where large transactions in equities, bonds, and foreign currencies occur daily. They are invisible to the public and other participants in the dark pool.
Institutional trading is global and can have a huge impact; the strategies and quantities of securities being traded can literally move their respective markets. To minimize this impact, institutional trading is often done in secret on legal, private, alternative trading systems (ATS), called “dark pools.” Below, we’ll dive into how dark pools work and if they impact your investment portfolio.
Definition and Examples of a Dark Pool
Dark pools are digital private markets where institutional investors such as pension funds, mutual funds, banks, corporations, sovereign wealth, hedge, and private equity funds trade.
- Alternate name: Alternative Trading Systems (ATS), private trading networks, alternative trading networks
Dark pools offer very specific trading methods, but they broadly work in two ways:
- They can match buyers and sellers at prevailing exchange prices (such as the midpoint between the bid/ask exchange price)
- They can operate as limit order books that execute trades based on price and time priority
In April 2021, dark pools executed about 13% of all U.S. equity trades, according to an analysis by institutional brokerage firm Rosenblatt Securities.
In practice, dark pool trading provides some important benefits, such as the ability to trade a large volume of stocks while minimizing information leakage.
“This protects fund orders, to a certain extent, from market participants that would seek to profit from knowledge of a fund’s trading intentions or strategies,” an Investment Company Institute (ICI) spokesperson told The Balance in an email. “Protecting confidential trading information reduces fund trading costs and provides greater returns to their investors.”
On the flip side, since there is no disclosure about large volume trading in dark pools, the shares that trade on the open market don’t necessarily reflect the demand and supply of shares accurately.
How Were Dark Pools Created?
Dark pools began after the Securities and Exchange Commission (SEC) made a regulatory change in 1979. Traders wanted lower execution costs and did not want competitors to know what, when, the price, and quantity of instruments they were trading. As a result, dark pools were created so that prices were not publicly displayed.
The first dark pool was created in 1986, with the launch of Instinet’s trading platform called After Hours Cross. It allowed investors to place anonymous orders that were matched after the markets closed. Just one year later, in 1987, a second platform emerged in the form of ITG’s POSIT.
According to a 2015 Credit Suisse research note, the rise of dark pools can be attributed to three factors:
- Regulatory changes
- Better trading technology
- A decline in market volatility
Among the regulatory changes that led to the evolution of dark pools, the big ones include the adoption of Regulation of Exchanges and Alternative Trading Systems (Regulation ATS) in 1998 and the Regulation of National Market Systems (Regulation NMS) in 2005.
Regulation ATS created a framework to better integrate dark pools into the existing market system and to alleviate regulatory concerns surrounding them.
In 2005, the SEC released Regulation NMS and opened the New York Stock Exchange (NYSE) to automated trading.
Aside from these critical regulatory changes, advances in financial communications technology accelerated new hybrid strategies, such as flash and algorithmic trading that relied on speed, large order sizes, and liquidity to contain trading costs. All these were available in dark pools, but soon there were problems. The “flash crash” of 2010—an event that lasted about 36 minutes and wiped out almost $1 trillion in market value—showed that more regulation was needed to control high-frequency trading.
Purposes of Dark Pools and How They Work
The origins of dark pools are tied to five non-regulatory factors:
- Reduced transaction costs
- Lower market volatility
- Greater trader autonomy
- More trading efficiency
- The need to avoid technological trading errors
The popularity of dark pools also stems from their specific trade execution formats and specialties. Almost all dark pools run as electronic limit order book markets. Some operate on a continuous trading basis throughout the day, while others are block trading-cross platforms. Some operate as non-displayed limit order books, while others execute orders at the exchange midpoint, and others that quickly accept or reject incoming orders. They also charge lower fees than traditional exchanges.
How Dark Pools Affect Individual Investors
While the dark pool market has expanded, it is still not clear how it impacts public stock exchanges where most individual and retail trades are conducted.
While they are not well-known, 60 dark pools were in operation as of May 2021, according to a list on the SEC’s website.
With their growing popularity, regulators are concerned about issues related to market quality, price improvement, and market integrity. In 2018, the SEC adopted Rule 304 as an amendment to Regulation ATS to require the filing of Form ATS-N which includes a variety of disclosures about dark pools.
Dark Pools and Mutual Funds
Nearly 46% of American households owned mutual funds in 2020, a survey conducted by ICI found. And while dark pools are not something you as an individual investor may directly come in contact with, some mutual funds in your portfolio may deal with dark pools.
According to Doron Narotzki, associate professor of accounting at the University of Akron in Ohio, some smaller mutual funds are using dark pools because they “need the trade volume to survive just like any other investment platform, and nowadays most dark pools will allow smaller investors to buy and sell through them. As a result, even smaller mutual funds can now use dark pools in order to make their orders and take advantage of what dark pools have to offer.”
So where does this leave individual investors? Since 2014, the Financial Industry Regulatory Authority (FINRA) “has worked to improve market transparency and improve investor confidence by displaying activity levels in each ATS, including all dark pools,” Narotzki said in an email to The Balance.
Under FINRA's transparency initiative, details of total shares traded each quarter by security in each ATS or dark pool are displayed on its website free of charge.
- Dark pools are private electronic markets that trade stocks, bonds, and currencies where institutional traders’ orders are not publicly displayed, regardless of size.
- They may not affect individual investors directly, but regulators worry about the negative impact on price discovery and market quality.
- Dark pool exchanges are highly specialized and cater to a variety of sophisticated trading strategies and different order execution models.
- Trades on dark pools are done at a lower cost than those done on traditional exchanges, but there is less transparency.
Frequently Asked Questions (FAQs)
How do I see what portion of a stock’s trades take place in a dark pool?
Based on SEC and FINRA regulations, individual investors can see order flow numbers to dark pools, but not individual trades. By definition, dark pools are secret, so that excludes details about stock trading.
Where are the dark pool trading sites?
The SEC lists all the dark pools on its site. Most of the major dark pools are broker-dealers and are primarily located in New York. These dark pools are under the jurisdiction of the SEC and FINRA. The list includes all types of dark pools that primarily trade stocks and bonds that accommodate a variety of algorithmic strategies, such as high-frequency trading (HFT) strategies that send portions of orders to different dark pools in various sequences.