Investing > Complete Guide to Dark Pool Trading

Complete Guide to Dark Pool Trading

Dark pools sound like a villain. While these alternative trading systems are legal and regulated, they're also quite controversial.

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Updated January 09, 2023

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If you have the power to move the market with your trades, you ideally want the market to react as late as possible when you make them.

For example, let’s say you suddenly want to pull an Elon and buy a billion dollars worth of Twitter shares (before he decided to buy the entire company). If you place your order on a public exchange like the NYSE or the Nasdaq, every trader would be able to see your play and react to it before your massive order gets executed.

Without question, this would increase the acquisition cost for you as other traders could front-run your huge order and profit before it’s completed. 💸

Fortunately, there is a way you can retain the anonymity of your trades legally (up to a certain extent). It might sound like a conspiracy theory, but several legal opaque institutional trading markets are allowed to hide quotes and report orders only after being executed. These “alternative trading systems” that hide trade quotes are known as dark pools.

This article looks at what dark pools are, how they work, their advantages and disadvantages, and how they have actually affected markets – in reality.

What you’ll learn
  • What is a Dark Pool?
  • How Dark Pool Trading Works
  • The Purposes of Dark Pool Trading
  • The Benefits of Dark Pool Trading
  • The Drawbacks of Dark Pool Trading
  • Dark Pool Trading Examples
  • Can Individual Investors Access Dark Pools?
  • Conclusion
  • FAQs
  • Get Started with a Stock Broker

What is a Dark Pool? 📚

A dark pool is a private exchange that allows investors to trade securities while providing them anonymity. These types of exchanges are usually preferred by institutional investors who want to avoid getting front-run or allowing the wider market to gain information on their trades. While they might sound shady, private exchanges are completely legal in the United States and regulated by the SEC.

Today we take instant, commission-free stock trading platforms for granted, but trading wasn’t always electronic. There was a time when traders would pick up the phone and process orders for their clients while charging a pretty hefty commission (roughly $3 to $40).

Back in those days of manual trading, traders on the floor would often use a system known as the open outcry, using hand gestures and verbal communication to quickly execute trades for their clients. The problem with this system is that all the traders can hear or see the trades being made. If the trade was considerable, then that information becomes valuable instantly.

Over time, trading shifted to digital and open outcry essentially went out of fashion. Nasdaq was formed in 1971, which provided traders with a digital ticker for stock prices updated in real-time. Still, electronic trading was mainly popularized with systems like Globex (1992) and, more significantly, E*Trade in the 80s and 90s. Around the same time, the SEC created the 19c3 rule that allowed listed stocks to be exchanged outside the physical confines of an exchange for the first time ushering in a new era for trading. 👨‍💻

The earliest dark pools were created by a company called Instinet in the 80s. These alternative markets were designed to help institutions trade large blocks of shares anonymously and in parallel to the public market. However, until the late 2000s, trading on these exchanges only represented 4% – 5% of the total trading volume. It was also often referred to as “upstairs trading,” implying it was only for the big boys, i.e., institutional investors.

Over time, the SEC would bring reforms to the market and attempt to regulate dark pools to varying degrees of success. By 1998, Regulation ATS (Alternative Trading System) was established, which created several rules for these entities—for example, they would have to register as broker-dealers or exchanges with the Financial Industry Regulatory Authority (FINRA), and have to disclose more information if the volume on exchange for one stock exceeded 5% of the average daily traded volume for that stock. 🛡

After that, Regulation NMS was enforced by the SEC in 2005, but instead of discouraging investors from using dark pools, it had the opposite effect. In fact, regulations had little effect on their growing popularity and volume. In April 2021, they were responsible for up to 13% of the total monthly trading volume in the country.

Dark pools also made headlines during the 2010 Flash Crash. Many accused private equity markets of enabling high-frequency trading (HFT) to run amok on their markets, leading to systematic problems for the border market, which led to the market crashing extremely quickly.

Chart depicting the sudden market crash that occurred at 2:30PM on May 6, 2010.
May 6 2010 was an unsettling day for investors when Dow Jones Industrial Average plummeted by 1000 points in 10 minutes. The market recovered shortly afterwards.

Senator Ted Kaufman, presiding as the senate chair during that time, said, “There is no way to know what is going on. No one knows what is happening in these exchanges when this trading is going on. We have a very dangerous situation.”

Dark pools remain legal and regulated by the SEC despite the concerns over them growing over the last few years. They are likely permitted to operate because they also offer several advantages to the market. While we cover that and its disadvantages below, let’s first look at how trading in a private exchange actually works.

How Dark Pool Trading Works 👷‍♂️

Imagine one of your friends calls to ask if you would prefer to trade shares on the digital exchange he created in his basement. “It’s not exactly the Nasdaq, but it’s all connected, trust me, bro,” he says. 

Furthermore, to give you an incentive for using their exchange instead of the Nasdaq, he offers lower trading costs (as he doesn’t have to deal with the infrastructure costs that Nasdaq does) and promises to keep your trade volume hidden from other traders. Dark pools are essentially the same, except they are run by massive businesses and banks like Goldman Sachs and Barclays, instead of some guy next door.

Also, while you can simply dismiss your friend and use an app to trade stocks, institutional investors do not have this choice. The size of orders executed by these investors could simply not be accommodated by a consumer-broker, like Robinhood for example, without severely affecting the market.

Like your hypothetical friend’s DIY exchange, dark pools offer traders many advantages, such as hiding trades from the general market, offering faster execution, and cheaper commissions compared to public exchanges.

Dark pools essentially run exactly like electronic exchanges for traders, except there is no market depth data. While public exchanges like the Nasdaq offer real-time data on market volume, private exchanges can keep the volume data hidden up to certain limits allowed by regulations.

In fact, many dark pools are created by brokers who use them to manage their internal order flow more efficiently, but they are not the only ones to run private exchanges.

Types of Dark Pool 🗃

In general, there are usually major three types of dark pools if you categorize them functionally:

  1. Broker-owned dark pools: These are operated by brokers such as JP Morgan, Citi, and Barclays. Most of the trades executed in these types of pools come from the broker itself—either on the behalf of their clients or from their prop desks. The price discovery in these pools comes from their internal order flow. Some good examples of broker-owned dark pools are JPMX by JP Morgan and Sigma X by Goldman Sachs.
  2. Exchange-owned dark pools: While most private exchanges are usually associated with trading that takes place outside public exchanges, several public exchanges also run their own trading systems to offer similar benefits. However, the price discovery for these pools does not come from their internal order flow but rather from the trades on the exchange. A good example of an exchange-owned dark pool is the NYSE Euronext.
  3. Independent dark pools: Finally there are some dark pools that are created by independent companies such as Instinet and Getco. They offer no price discovery and are usually focused on providing novelty features such as extremely fast execution times which help traders follow HFT strategies.

The Purposes of Dark Pool Trading 👨‍🏫

The initial problem that dark pools solved is pretty easy to understand—institutions wanting to trade large blocks of shares without worrying about front-running or cost of execution. By shielding their moves from the border market, they can get a better deal. 

For brokers, having their own private exchange carries several advantages too. For example, routing orders through their internal dark pool would usually be cheaper than routing them through public exchanges. Additionally, their prop desks could easily access the firm’s liquidity in the pool. Doing so in a public exchange is not easy.

So, one of the primary purposes of using dark pools was to protect one’s trade against high-frequency automated trading and its predatory practices on public exchanges. However, over time, it became apparent that high-frequency traders were now accessing them as well. For example, in 2016, Barclays agreed to pay $105 million in total fines for allowing increased high-frequency trading activity on its private trading system.

Dark pools again became a controversial subject with the Gamestop short squeeze. Many traders blamed brokers for colluding against retail investors and using them to artificially control stock prices.

While there are a lot of negatives that come with the concept, dark pools can also be beneficial to the market (up to a certain point).

How Markets Benefit from Dark Pool Trading

One of the most common benefits of dark pools is that they reduce volatility in the market and lower market impact from large institutional orders. While it might affect price discovery up to a certain point, the market could become quite chaotic if institutions used the consumer-level trading systems for all their trades. 📊

The second benefit that dark pools offer is lowered trading costs. It is much more likely to find matches for huge orders and execute them in a private exchange than it is in a public exchange. Additionally, private security exchanges could possibly find a better match for a huge order than a public exchange could, where the order would have to be broken up into batches.

For example, it might be possible to trade 100,000 shares of a company in a dark pool with a willing counterparty for the entire trade. Yet the same order might have to be broken into 10 batches of 10,000 shares to fulfill the order on the Nasdaq. This is due to the fact that most trades on private exchanges are initiated by institutions and the average volume for the trades are significantly higher than anything seen at a retail level.

Lastly, dark pools were initially proposed as a way to counter automated high-frequency trading and its predatory practices of front-running orders. However, recent events have shown this to actually not be the case. 📅

Overall dark pools tend to come with many benefits for their users. They are operated by the most prominent brokers and even public exchanges like the Nasdaq because of the benefits they offer. However, it is easy to make a case that they damage the market and are bad for retail investors.

How Markets Get Damaged by Dark Pool Trading ⚠

It should not be a surprise that an alternative trading system that obfuscates market data on purpose could technically allow its operators to manipulate the markets and gain advantages over the average retail investor.

Both regulators and traders have expressed concern over the use of dark pools by institutional players in the market. Some of these concerns are:

  • Effects on Price Discovery
    Due to the way in which dark pools work, it is likely that the general stock market prices are not an accurate representation of the stock’s value. The lack of information could technically put retail investors at a disadvantage when trading.
  • Unfair Use of Dark Pools by Brokers
    Dark pools owned by brokers are particularly worrisome as they can be exploited by the operator by strategies like front-running. Additionally, it also creates a conflict of interest as the broker’s proprietary traders gain an advantage and could trade against the clients more effectively.
  • High-Frequency Trading
    Initially, dark pools were created to protect trades against high-frequency trading. Yet regulatory fines would suggest that high-frequency traders can and do use them frequently to run predatory trading strategies.

Dark Pool Trading Examples 📝

Now that we have covered what dark pools are, how they work, and the risks and benefits, let’s look at some real-life examples of these entities and how they impacted the market. Unfortunately, they are rarely in the news for positive reasons.

For example, the New York Attorney General sued Barclays in 2014 due to the firm’s unethical use of its proprietary trading system Barclays LX. The case was settled for $105 million eventually. It was based on Barclays not providing adequate disclosure to their clients regarding high-frequency traders. While the investment bank claimed it monitored its dark pool for high-frequency traders, it was later proven that it did not. 👮‍♂️

By allowing high-frequency traders to use the systems freely, a conflict of interest arose for the firm as they were essentially pitting their clients against the fastest and most predatory trading strategies. It is particularly concerning as dark pools were promoted to avoid those strategies in the first place.

On the other hand, some exchange-owned pools like the NYSE Euronext were established in response to private exchanges with conflicting interests. While NYSE Euronext works like a typical dark pool and achieves the same goal, there are some safeguards for the investors. For example, the trading doesn’t occur in complete darkness, and all trades must consider the stock’s price on NYSE before executing the trades. 💰

The most controversial and recent example of a dark pool in real life is the story of Citadel Connect’s involvement in the Gamestop short squeeze saga in 2021.

Due to an unprecedented surge in trading volume for meme stocks, Robinhood had shut down trading for those particular stocks.

The commission-free platform had become one of the most commonly-used brokers by retail investors, who were cut off from acquiring more shares of the company they wanted. There were many lawsuits over this which led to some interesting information.

For example, it was revealed that Citadel Securities was paying Robinhood millions of dollars for its order flow. By selling their clients’ order flow, commission-free platforms like Robinhood could continue offering their services for free. However, this also effectively meant that Citadel had access to real-time information about retail trades before they occurred.

It is not hard to imagine how valuable that information could be for creating better trading algorithms that can front-run retail traders using the firm’s dark pool for faster and cheaper execution and easily outperform retail investors. Robinhood was fined $65 million in a settlement with the SEC relating to order-flow violations.

Is it Possible for Individual Investors to Access Dark Pools? 🤔

If you are an individual investor, you will most likely not be able to access dark pools. Most private exchanges usually only allow institutions with massive orders (astronomic relative to retail investors). 

However, much of the benefits that dark pools offer do not apply to small trades. It is doubtful that retail investors could move the market with a single trade, so seeking protection against that is a non-issue.

Additionally, front-running retail orders only become an issue when it’s systematic as market makers gain an advantage in terms of information. Yet the average individual investor should not be massively concerned about front-running on single orders.

So even though dark pools cannot be accessed by individual investors, knowing about them can help them get a better understanding of the intricacies that exist within the stock trading system. 

Conclusion 🏁

Dark pools have existed for decades, with the first ones established just within a few years of electronic trading becoming a possibility. They initially handled only a small percentage of the overall market. However, the trading volume on them has only increased over time. Furthermore, today’s highly digitalized trading systems allow both operators and traders to use them more effectively and elaborately. 

While they may benefit the overall market, the benefits do not outweigh the potential problems. After the short squeeze in 2021, the dark pool debate was ignited again as retail traders started wisening up to shady tactics used by the big players in the market. 

As of now, dark pools are still legal and regulated by the SEC. While the watchdog has stated it’ll look at these systems closer to provide a more fair game for all, it is unlikely that they would ever be completely shut down.

However, a silver lining to the entire saga is increased awareness among retail traders. By making it through the whole article, you know almost everything about dark pools and how they work. Hopefully, this knowledge will help you peer through the fog and see the stock market for what it really can be, sometimes.

Trading via Dark Pools: FAQs

  • How Can I See Dark Pool Trades?

    You can see dark pool trades by visiting the website of the Financial Industry Regulatory Authority (FINRA). Do note that trading data is only available after the trades have been executed. It is still not possible to obtain live market depth data for dark pools.

  • Are Dark Pool Trades Reported?

    Yes, dark pool trades are reported but only after the trades have been executed. Initially, it was not possible to determine which dark pool was executing the OTC trade but with new regulations, dark pools need to also report where the trade took place.

  • Are Dark Pools Legal in the U.S.?

    Dark pools are completely legal in the US and are regulated by the SEC. Various SEC regulations control how alternative trading systems can behave.

  • Do Dark Pools Harm Price Discovery?

    Dark pools do harm price discovery but only up to a certain point. Since all the trades are eventually reported by the dark pools, the new data allows for price discovery for the asset.

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All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.