What are dark pools in trading?

What are dark pools in trading?

In our previous discussion on electronic communication networks (ECNs), we explored how these platforms can expose investors to the risk of front-running by high-frequency traders. When utilizing ECNs, there is a possibility of having your order observed by others, allowing them to swiftly place their own orders ahead of yours.

Moreover, another issue arises when attempting to purchase a substantial number of shares through a large order, which can lead to an impact on the stock’s price. Additionally, traders may front run your order as the market faces difficulty in surpassing the obstacle posed by your significant order.

Consequently, these challenges have created a need for dark pools.

What are dark pools?

Dark pools, also known as dark liquidity pools or dark trading venues, are private electronic platforms or exchanges where large institutional investors, such as hedge funds and investment banks, can trade securities.

They are called “dark” because the trading activity that occurs within them is not visible to the public.

In traditional stock exchanges, such as the New York Stock Exchange (NYSE) or NASDAQ, trades are executed on a centralized and public order book, where bid and ask prices are displayed and accessible to all market participants. Dark pools, on the other hand, operate off-exchange and offer a level of anonymity and reduced transparency.

The main purpose of dark pools is to allow institutional investors to execute large orders without revealing their trading intentions to the broader market. By trading in a dark pool, these investors can minimize price impact and avoid affecting the market price of the securities they wish to buy or sell.

Dark pools employ alternative trading systems (ATS) that match buy and sell orders internally, within the pool, or through connections with other dark pools or exchanges. This internal matching process ensures that the trading activity remains hidden from public view until the trades are executed.

Dark pools have been in existence since the 1980s and currently account for approximately 15% of the trading volume in the US market.

There are several reasons why institutional investors may choose to trade in dark pools:

1. Reduced market impact

By executing trades away from public exchanges, investors can avoid moving the market against their positions, especially when dealing with large orders.

2. Increased privacy

Dark pools provide a level of anonymity as the identity of the trading parties and the details of their orders are not disclosed to the wider market.

3. Improved execution quality

Dark pools can offer improved price execution compared to public exchanges, particularly for large orders, by leveraging their internal matching algorithms and liquidity.

4. Mitigation of high frequency trading (HFT)

Dark pools are often seen as a way to minimize the influence of high-frequency traders who thrive on speed and access to order flow information.

It’s important to note that while dark pools can provide benefits to institutional investors, they also raise concerns regarding transparency and fairness in the overall market. Regulators closely monitor these trading venues to ensure compliance with regulations and to maintain market integrity.

Now, let’s delve into an example that illustrates how dark pools operate.

Example:

Suppose you intend to purchase 20,000 shares with a maximum price limit of $14. This implies that the highest price you are willing to pay for a stock is $14. However, it is important to note that you cannot simply buy all the shares at $14 due to restrictions on executing orders outside the National Best Bid and Offer (NBBO).

In other words, if the best bid and offer available for the stock are $10 and $11 respectively, you can only trade the stocks at that particular price range. Purchasing them at $14 would not be possible in this scenario.

If there is an offer of $10 available in the dark pool, you can proceed with executing your order. However, if such an offer is not present, you will need to wait until a suitable opportunity arises.

When you place an order in a dark pool, your order is added to their book without being visible to anyone else. This is why it is referred to as a “dark” pool, as it remains concealed from public view. On the other hand, other electronic communication networks (ECNs) and exchanges are sometimes referred to as the “lit” market because they operate in the open, making all orders and information visible to everyone.

In addition to orders being invisible in dark pools, the operational mechanisms of these pools remain unknown. Unlike ECNs and exchanges, where time priority and price priority are known factors, dark pools operate with undisclosed order execution methods.

Each dark pool operates uniquely, varying from one another in terms of their functionality. Different dark pools may employ different rules and mechanisms for order execution. For instance, one dark pool may prioritize the largest order, while another may prioritize the order that has been waiting the longest. As a result, even if you have a more favorable price in one dark pool, it doesn’t guarantee that you will receive the fill, as the execution priority differs among pools.

The reason for this is that dark pools primarily serve the purpose of allowing large institutions to trade significant volumes of shares without constantly falling victim to front-running.

However, traders’ objectives revolve around identifying and capitalizing on large orders, understanding who intends to buy or sell, and front-running these substantial orders. This practice is a common goal among traders. As mentioned in previous discussions, we explored how support and resistance levels are formed by significant orders, illustrating a similar scenario.

Hence, in their quest to locate these substantial orders, many traders have adopted a technique known as “pinging.”

The practice of pinging involves sending small orders to various stocks within dark pools, often carried out by teams of traders. Although these pings may not result in immediate fills most of the time, if one of the orders is filled, it indicates the presence of a significant buyer in that particular dark pool for that specific stock.

For instance, suppose a successful ping involved selling 100 shares at $10.50. In response, the traders would proceed to purchase as many shares as possible within that price range from the visible offers in lit markets, let’s say 5,000 shares.

They would then place a bid for 100 shares at a higher price, such as $11. At this point, the bid and ask prices would be $11 and $12 respectively. They would ping the dark pool once again by sending an order to sell 100 shares at $11.50, resulting in a fill because the large order is still present in the dark pool. Subsequently, they would attempt to buy everything available within that price range from the lit market, once again let’s say 5,000 shares at $12. As a result, they would raise the bid price to $12, causing the bid to be $12 while the ask remains at $13.

This process would be repeated until they either fail to receive a ping back or the order fails to fill within the dark pool. Suppose the ping failed at $14.50, exceeding the maximum price limit of $14 at which you are willing to buy the stock. They would then adjust the bid back to below $14, for example, $13.50, and sell all the allocated shares to you at that price using this methodology.

Despite utilizing dark pools, you still experienced front-running, which is something dark pools are designed to protect against.

This is precisely why dark pools maintain discretion regarding their operational methods. Various dark pools impose different rules to safeguard their clients from being exploited. For example, certain dark pools prohibit the submission of small orders, while others enforce a restriction on order cancellations within a specific time frame, such as an hour. These diverse rules aim to protect clients from being manipulated or gamed within the dark pool environment.

The primary advantage of dark pools is that they help institutional traders reduce the market impact of their trades. Additionally, trading in dark pools often incurs lower transaction fees compared to traditional exchanges, providing a slight cost advantage.

However, the drawback is the lack of transparency regarding their operational methods. As a result, it becomes uncertain whether one is obtaining the best price for a stock. Moreover, these pools are vulnerable to strategies like the ones mentioned earlier. However, it is worth noting that these strategies are not as effective anymore, as dark pools have become more sophisticated and are less susceptible to being gamed. Nevertheless, in the past, such strategies had a significant impact and were successful.

When analyzing your time and sales data while trading, observing frequent occurrences of dark pool trades indicates the participation of institutional traders rather than retail traders.

For further information, you can refer to the relevant entry on Wikipedia to delve deeper into the subject.

To enable retail traders to access dark pools indirectly, IBKR provides the Dark Sweep method, which incorporates dark pool liquidity into your order to reduce the market impact.