What are Dark Pools?
Dark pools are essentially private exchanges for trading securities, meaning that they are unavailable for typical retail investors
[1]. If we picture an iceberg and place all the different capital markets, all the different types of investors and traders, all the asset classes, all the financial regulators and everything else that belongs to the market’s ecosystem, we get all the “systems” that are publicly available for us to see. Below the water, located would be the larger part of the iceberg, but we wouldn’t be able to see it from the surface – this is where dark pools would be.
Dark pools are a way for investors to hide their trades from the total exchange. Don’t get me wrong here; dark pools are not some sort of “black market”. These exchanges are so named due to their lack of transparency, meaning that investors have the opportunity to place orders and make trades without the general public knowing about it. The irony of dark pools is that they’re not a secret at all. In fact, anyone with a username and password to Bloomberg Terminal has access to Bloomberg’s Tradebook and voilá: dark pool
[2]. However, Bloomberg’s dark pool is an “aggregator” and is only one of many types of dark pools. I will tackle the different kinds in the second article.
The next thing you must be wondering is, “surely if dark pools are a way for investors to hide their trades, they have to be somewhat illegal right?”. The answer is mostly no because the purposes and usages of dark pools are more for preventing certain liquidity issues with securities.
For the majority, they actually allow deep-pocketed investors to do some neat stuff without doing too much damage to a stock’s market value (or any other asset class). For example, if a hedge fund has strong evidence to believe a buyout between two large companies will happen, they might place a trade through a dark pool using a block trade if they want to trade a huge number of shares – and we’re not talking about 100 or 200 thousand shares.
If regular investors knew about the merger, the stock would rally since everyone would load up on that stock, meaning the hedge fund wouldn’t profit as much. For instance, regular investors may monitor
trader sentiment tools such as Stockgeist.ai to keep up to date the market psychology following press releases and news leaks. So in this case, dark pools also serve as a protection mechanism to avoid mispricing due to a large volume of orders.
Dark pools are mainly used when you want to move size, and anonymity is key – they have nothing to do with other trading methods like arbitrage. That’s why it’s useful to interpret them simply as shares bought or sold in the dark. Of course, an issue arises when traders start misusing dark pools for personal benefit, especially for insider trading – but let’s leave that for the SEC to deal with.