Can You Swim in a Dark Pool?

If you’re interested in over-the-counter (OTC) trading, you might have heard discussion about dark pools, a type of alternative trading system (ATS) that was designed, in general, to handle large trades for institutional investors anonymously.

Most retail investors won’t directly interact with dark pools, so understanding exactly what these venues are and why they exist can be difficult. Let’s shed some light on the darkness.

What's a Dark Pool?

Also known as “dark pools of liquidity,” dark pools were originally designed to accommodate large buyers and sellers ready and willing to trade large blocks of shares without causing the market to move against them. The goal was for this liquidity to provide smoother trading and mitigate large price swings or market dislocation.

The pools are called “dark” because they don’t broadcast pre-trade data—i.e., the presence, price and size of buy and sell orders—the way that traditional exchanges do. As a result, dark pools don’t contribute to the public “price discovery” process until after trades are executed. They do, however, need to report information about trades that occur.

Dark pools aren’t new. The concept of crossing trades off exchange has been around nearly as long as stock exchanges themselves. In the past, such trades would take place at a broker-dealer’s trading desk, away from the market floor. (Historically, these desks were upstairs above the trading floor, which is why off-exchange or block trading is sometimes referred to as “upstairs” trading.) But dark pools took off as an alternative to exchange trading beginning in the late 1990s as trading technology and regulation evolved.

What Purpose Do They Serve?

In theory, a dark pool allows institutional investors—organizations that invest large pools of money, including insurance companies, mutual funds and pension funds—and others to execute large orders while seeking to reduce the impact on the prices of the stocks they’re buying or selling.

If an institutional investor wanted to sell 500,000 shares on a traditional exchange, for example, they would likely have to do so in a series of smaller trades. This could create downward pressure on the stock price as it became apparent that a large seller was in the market.

With a dark pool, there’s no publicly available order book, so buyers and sellers have a better chance of completing an entire, larger trade without triggering a price move.

Generally, that can be seen as a good thing for the large institutional investors that trade on behalf of their clients—those that invest in their investment funds—and potentially for market efficiency overall.

What Are the Chief Concerns?

One concern is that when large trades take place off traditional exchanges, the price of shares simultaneously traded on the open market might not accurately reflect market supply and demand. As noted above, dark pools don’t contribute to price discovery in the same way that traditional exchanges do.

At the same time, because dark pools necessarily rely on public prices as a benchmark for their trades, and generally under the U.S. Securities and Exchange Commission’s (SEC’s) Order Protection Rule must execute trades at prices at least as good as the best publicly available, dark pools benefit from the pre-trade pricing information provided by those exchanges.

What Are Regulators Doing?

Though their name might make it sound as if these venues lack transparency or oversight, both the SEC and FINRA are actively involved in the regulation of dark pools.

All trade data for listed stock transactions occurring on ATSs, including dark pools, must be submitted to a FINRA Trade Reporting Facility (TRF) and is published on the consolidated tape, an electronic system that provides real-time trade data for listed securities.

FINRA makes weekly trading information for each equity ATS publicly available after a two- to four-week delay, depending on the type of stock, in an effort to enhance transparency in that market. FINRA also publishes data for trades conducted over the counter on other venues.

Publishing this data allows market participants, investors, regulators and academics to see volume information and trends in dark pool trading on a stock-by-stock basis. It can also help firms refine their trade routing strategies to reduce costs, enhance market transparency and generally improve trading quality.

Additionally, SEC regulations generally require ATSs to be operated by FINRA member firms, subjecting them to applicable securities laws and regulations. ATSs are also subject to additional fair access requirements, and those that trade listed securities must submit disclosures regarding the nature of their trading operations via Form ATS-N. The SEC publishes those disclosures, along with a regularly updated list of ATSs, on its website.