What Is a Dark Pool?

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DEFINITION

A dark pool is a private trading system or exchange used to trade securities anonymously, where the details of the trades aren’t revealed publicly until after the trade is executed. Dark pools stand in contrast to traditional “lit” pools, in which offers to buy or sell securities are made publicly and transparently.

Definition and Examples of Dark Pools

A dark pool is a place where securities transactions take place in the dark, metaphorically speaking. Within dark pools, traders typically can’t see other parties’ information regarding buying and selling securities until a transaction goes through. These transactions are a type of alternative trading system (ATS) operated by a broker-dealer rather than going through a public exchange like the New York Stock Exchange (NYSE).

On a public stock exchange, you can see bid-ask spreads and traders can publicly see information such as the quantity of shares that a market participant is trying to buy or sell. Since this information is easily visible and transparent, these exchanges are considered to be “lit,” as if a light was shining on the activity taking place on the exchange.

One of the top reasons why investors and traders use dark pools is to obtain better pricing by remaining private. Within a lit exchange, an institutional investor—such as a large pension fund—might try to sell thousands or millions of shares. This could quickly cause the price to drop before the transaction finalizes, as others could see that someone is trying to get rid of a lot of stock.

Within a dark pool, however, the pension fund could try to sell all the shares they want to get rid of all at once (before the price can move against them). The fund could do this by matching with a buyer who agrees to the transaction price ahead of execution.

How Do Dark Pools Work?

Dark pools work by having broker-dealers or other parties, such as stock exchanges, set up private electronic venues to conduct trades.

Within these private platforms, suppose a trader wants to buy a stock at $100 per share for its client, but the lowest publicly posted bid price on the NYSE is a few cents higher per share. Instead of having to buy the shares for $100.05, for example, the broker could submit the order via a dark pool, hoping the private system has a match with another party willing to sell at that $100 price.

Those five cents might not seem like a big deal when trading a few shares, but the stakes change when dealing with institutional orders, which can encompass hundreds of thousands of shares. Small differences in pricing for both buying and selling securities can add up, especially when trading happens frequently.

Criticisms of Dark Pools

While dark pools are legal, they have come under regulatory scrutiny because of their lack of transparency. Sometimes ATS/dark pool operators have engaged in dishonest behavior—like front-running orders (tipping off other traders about a dark-pool trade)—that’s led to enforcement from the U.S. Securities and Exchange Commission.

Ironically, dark pools were initially presented as a way to avoid front-running. This process occurs when a market participant, perhaps a high-frequency trader, takes the knowledge of an existing order that will move the market and then makes the same transaction first to obtain better pricing.

Sometimes, a dark pool’s lack of transparency can cause investors to get involved with dishonest private exchange operators.

What Do Dark Pools Mean for Individual Investors?

Individuals generally can’t access dark pools directly on their own, just as you can’t walk onto the floor of the NYSE to buy and sell stocks—orders have to go through financial professionals like brokers. Still, if your broker ultimately places your order through a dark pool, that can affect your returns. So you may want to ask your broker about their trading procedures and how they can help you obtain the best pricing through either lit or dark pools.

If you have a connection to an institutional investor—such as owning a pension fund or investing in mutual funds—dark pools can make an impact on you personally. A broker might be able to help these institutional investors obtain better pricing through a dark pool rather than paying the publicly listed price on a lit exchange. This can mean higher returns for these institutional funds, which can trickle down to the returns you see.

Key Takeaways

  • A dark pool is a private trading platform wherein trade details can remain anonymous until execution.
  • These private exchanges can potentially lead to better pricing for market participants, such as by avoiding the price movements caused by other traders seeing large trade offers.
  • Dark pools lack transparency compared to traditional lit exchanges, which could negatively impact some market participants.

Article Sources

  1. U.S. Securities and Exchange Commission. “Shedding Light on Dark Pools.” Accessed Dec. 8, 2021.