Dark Pools and High Frequency Trading For Dummies
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Dark pools have grown to be a major part of the global equity markets, and they’ve become a real competitor and alternative to traditional stock exchanges. Many investors are confused about dark pools because of rampant rumors, which isn’t surprising. Just the name is enough to put fear into anyone who takes an interest in them.

When you take a dip in a dark pool, you’re swimming in murky waters. Whether you like it or not, if you’re buying or selling equities, the chances are you’ll be operating in a dark pool at some point. They’re as much a part of the global financial markets as the iconic New York Stock Exchange, the City of London, or Wall Street itself.

Because there is so little knowledge of what happens in dark pools, these ten things about dark pools are important in helping you understand how they affect the markets and, more importantly, how they can affect you and your equity trades.

Dark pools are dark, not transparent

Trading in dark pools is all about visibility and, as the name implies, dark pools don’t have a lot of visibility. In a traditional stock exchange, when you send an order to the market with a price limit, that order shows up on the exchange’s trading book. It’s there for all to see in public. Only the price and the number of shares you want to trade are visible.

You don’t have this type of transparency in dark pools. A dark pool doesn’t show how much of a stock you want to buy or at what price, which is what makes dark pools dark. To differentiate, traditional stock exchanges are sometimes referred to as lit or displayed markets.

Dark Pools are for everyone

Originally, dark pools were set up so that only big, institutional investors could buy and sell large orders of stocks with other big, institutional investors without making a big price impact on the market. When orders are displayed in a market, everyone can see the intentions of all the buyers and sellers. A big order could easily alert others to someone who was desperate to buy or sell, which could cause a change in the price. Without showing the size of the trade, big institutions were able to find matching orders without letting the market see the size of their order.

That’s not the case anymore. Dark pools, just like stock exchanges, need people to trade in them; they need buy and sell orders. To attract more and more orders, many dark pools now let smaller orders, with smaller-sized trades, into their pools in order to create more liquidity (an abundance of orders at different prices from many different market participants). Executed orders in dark pools have been steadily decreasing over recent years, and dark pools are no longer the sole preserve of big institutions.

Dark pools are more and more prevalent

What began with a need for big institutions to get their trades executed with as little market impact as possible quickly turned into a great money-spinner for banks and brokers. If they could match client orders in their own dark pools, they wouldn’t have to pay the stock exchange’s fees and perhaps they could themselves do a bit of buying and selling in their own pools and profit even more. With this realization, banks and brokers began to promote and encourage the use of their own dark pools to a wider clientele, including retail investors. The spread of dark pools has made them an integral part of the current market structure, and there is now no escape from dark pools.

Numerous dark pools exist all over the world. In fact, a large part of the overall volume in stock trading on the major markets is now conducted in the dark. In the United States alone, estimates suggest that 40 percent of all executed trades are completed in a dark pool and about 20 percent in Europe. In other markets across the world, dark pools aren’t as common, but in any market that sees growth in equity trading, dark pools are sure to show up.

Dark pools need stock markets

Dark pools need traditional displayed markets. That’s how they determine the price of a stock. Because the price and the number of shares that are to be traded aren’t shown in a dark pool, the dark pool has to get its price from somewhere, which is why dark pools look to the displayed markets for a price benchmark.

The original matching of trades in a dark pool would be done based on the average price of the best bid and the best offer available on a displayed stock exchange. The best bid is the highest price a buyer is willing to pay for a stock, whereas the best offer is the lowest price a seller is willing to sell his stock. By matching a trade at the average of the best bid and best offer, both the buyer and the seller in a dark pool receive a better price than they would’ve received in the displayed market. This competitive edge of the dark pools is referred to as price improvement.

Dark pools have grown because of HFT

Originally, dark pools were designed for big institutions. Dark pools quickly grew, however, in part due to the growth of high-frequency trading (HFT) in the traditional displayed stock markets. Institutions now had an even stronger need to avoid what they felt was the predatory trading of high-frequency traders as the HFT crowd tried to sniff out large orders in the displayed markets.

As a result, more and more institutions traded in the dark. It brought about a problem for the dark pools, though. Who would be trading with the big institutions? Who would take the other side of the institutional investors’ trades? To satisfy the demand for more liquidity, some dark pools began letting high-frequency traders into their pools so that more trades could be matched.

Opening the door to high-frequency traders has resulted in exactly the same activity within dark pools that institutional investors tried to get away from in the displayed markets – predatory algorithms sniffing out big orders and trading against them.

Dark pools are preferred by banks and brokers

Banks and brokers are more than happy to execute trades in their own dark pool to improve on their own bottom line. As the size of the average executed trades on dark pools has decreased, more and more small orders are being routed to dark pools before being sent to the displayed markets.

Brokers may possibly try to match your order in their own dark pool. Doing so is okay as long as you get price improvement and an overall saving in your trading costs. Be sure to ask your broker whether he routes your orders via a dark pool or not.

Dark pools allow front running

Front running is when another trader knows that you’re about to buy (or sell) a stock and that trader then buys (or sells) the same stock before you’re able to and then immediately sells the stock to you at a higher price. Front running isn’t fair and is banned, but unfortunately, front running still happens in dark pools.

Some dark pool operators have been fined for such actions, and some are facing lawsuits. Some dark pools have been fined for breaking rules and facing the ire of regulators. Because of the way dark pools are set up and their lack of transparency, there is a real temptation to front-run orders. Be careful and know what dark pools your orders are being traded on.

Dark pools aren’t all the same

Dark pools come in many different guises. Their lack of transparency is the one unifying factor, but each one is a little different from the other because they all have their own specific rules on whom they allow to trade in their pools and under what conditions. Some dark pools have limits on trade sizes, only allowing large orders, also known as blocks, to be traded within them. Then others allow high-frequency traders to trade in their pools. Other dark pools even differentiate themselves with the way they match trades.

Dark pools are regulated

Dark pools aren’t a complete version of the Wild West in the financial world, as some market pundits would have you believe. Dark pools are actually regulated, with national financial authorities in the respective countries monitoring and policing their actions and the way that they conduct business. As dark pools have grown, regulators and legislators have taken a keener interest in the way that dark pools are run. As a result, dark pools are facing more and updated legislation to control how they operate.

Dark pools aren’t going away

Legislation will change and alter the way dark pools do business and how they operate, but dark pools are nothing new. The need to trade large blocks of shares with minimal market impact will always be part of the market. That’s why before the emergence of dark pools brokers discussed and agreed on block trades outside of stock market trading hours. Dark pools are simply the evolution from those times. When operated fairly with clear rules, dark pools can be beneficial for investors in search of both price improvement and minimal price impact. Investors will always need the option of having a dark pool to trade-in.

About This Article

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About the book author:

Jay Vaananen is a senior private banker with many years of experience advising clients in their investments across all asset classes. He is also a popular university lecturer and regular commentator in all matters regarding banking, finance and investing.

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