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In most people's minds, the stock market is represented by the flashing lights of New York and Nasdaq and other such traditional displays of activity. However, behind this façade is an industry that handles trillions of dollars in trades that take place entirely without anyone knowing. These trades occur in what are referred to as "dark pools" or "dark markets."
Dark pools are part of the current state of the global financial marketplace, not merely a figment of someone's imagination from a spy movie. We hope to allow our readers to understand better what their purpose is and how to utilize dark pools to benefit themselves as individual investor.
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How Do Dark Pools Work?
A "dark pool" is defined as a private financial platform that allows institutional traders to conduct their trades without exposing them to the general population of investors. When you see the industry term lit market, the industry has created an operating environment where the "order book" (book of pending trades) is visible.
This means that any pending order will be placed into the system. However, there will not be any way to determine who is attempting to execute the trade until after the trade has executed. The majority of the time, these trades will execute in less than 1 second.
Dark pool trading will generally consist of the following four steps:
Institutional Orders: Most institutional investors will initiate the request to execute a very large block of shares.
Matching Engine: The order will be placed into the "dark pool". Within the dark pool, the system will search for other participants who wish to match the request and place an order against the order.
Execution: After discovering a match on the Systematic Trading System™ (STS), the trade is executed at a predetermined price provided by the public exchange.
Reporting: The trade is reported to the consolidated tape after the transaction is final and reflects the transaction to the public.
To comprehend these concepts properly, one must study and understand Equity Market Basics: How It Works, Types, Advantages & More.
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Why Do Investors Go "Dark"? (The Benefits)
Many people are questioning why institutional "Smart Money" would choose to hide their trades from the public market. The advantages that dark pools provide for institutional investors are as follows:
Reduced Market Impact: If a fund were to attempt to sell 500,000 shares of stock on the public market, this would cause a sudden increase in supply, and therefore, the price of the security would decrease drastically prior to the completion of the order. By utilizing a dark pool, this type of trader avoids "slippage."
Price Improvement: A majority of dark pool transactions occur between the midpoint of the best available Bid and ask. This allows both buyer and seller the ability to achieve a better price than either could from the public market.
Reduced Transaction Cost: Dark pools generally charge lower transaction fees to the investor than the public markets.
Anonymity: Large players are able to access and exit positions without exposing their methods to their competitors. This is a major factor in how Smart Money Concepts (SMC) works.
The Three Main Types of Dark Pools
All dark pool venues are not identical. They tend to fit into one of three categories:
Broker/Dealer Owned - Set up by large investment banks (such as Goldman Sachs' Sigma X and Morgan Stanley's MS Pool) for their clients.
Agency Broker or Exchange Owned - Act as neutral agents who do not trade on their own accounts (such as Liquidnet). Public exchanges, like the New York Stock Exchange (NYSE), have established dark pool trading.
Electronic Market Makers - Private companies, such as Citadel Securities and Virtu Financial, operate dark pool venues where they are the principal and provide liquidity to the marketplace.
If you're interested in how trading in these venues is automated, consider reading "What is Algorithmic Trading and How Can It Help You Become a Better Trader?" to provide additional context and information.
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Dark Pools vs. Retail Investors
With respect to dark pools and retail investors, many people wonder whether or not dark pool trading is fair for everyday investors.
The major issue with dark pools is "price discovery." If 40% of the total volume of trades occurs in dark pools, then any "market price" that you see in your brokerage app may not reflect the actual market supply and demand. Moreover, some high-frequency traders use predatory methods to "sniff out" big orders executed in dark pools, which can create an unfair advantage for the high-frequency trader at the expense of the original trader making the order.
In addition to this, we see that dark pools are very beneficial for many retail investors, and not really in an overt fashion. Retail investors place assets with institutionals such as pension funds and mutual funds (which includes your every dollar), and when these institutionals utilise dark pools to execute transactions efficiently and not bring down the price on the exchanges, they actually protect the investors' investment value.
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Dark Pools vs. Lit Exchanges
To clarify further, we've created a graphic that illustrates the key differences between a dark pool and an exchange. Having a clear understanding of these different platforms is very important when creating an effective trading strategy for your investment portfolio.
Conclusion
Although dark pool trading is complicated and can be frustrating if you like total transparency when investing, it provides the liquidity and stability that will enable institutional investors to be able to trade large amounts of securities.
As a retail trader, you do not have to utilise dark pools to achieve your objectives. However, understanding how institutional investors operate within the Market will help you identify price movements in the market and develop your own profitable Intraday Trading Strategies for Beginners.
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