Below, we’ll take a look at what is a dark pool and the different types available. We’ll also discover why anyone would prefer dark pool trading over regular trading. Then, finally, we’ll check if there are any benefits and drawbacks when it comes to dark pool trading.
What are dark pools?
The answer to the question of what is dark pool trading is simple. It’s private, anonymous stock trading that allows large institutional investors to buy and sell shares. They get to do this without revealing their orders to the broader market.
These “dark” pools of liquidity are run by banks and other big financial firms. They are typically not accessible to retail investors and the general public. Dark pools intend to allow large investors to buy and sell large blocks of shares without moving the market.
Why to use dark pools?
Now that you know what are dark pool trades, let’s see why anyone would choose to use them. The main reasons are anonymity and privacy. But what else should you know?
- Price Discovery: Dark pools allow institutional investors to discover the true price of a security without revealing their intentions to the broader market. This can be particularly important when buying or selling large blocks of shares, which can move the market if executed on a public exchange.
- Better Execution: Those who know what is dark pool in stocks know that it provides institutional investors with better execution. They can negotiate the price and size of the trade with the counterparty. This can provide them with more control over the trading process, and better prices compared to trading on public exchanges.
- Access to Liquidity: Dark pools can provide access to liquidity for securities that may not be actively traded on public exchanges. This is beneficial for institutional investors looking to trade in less liquid markets.
Dark pool types
In addition to just knowing what is the dark pool, you also need to know the different types available.
- Alternative Trading Systems (ATS): These are dark pools that are not run by a broker-dealer. They are run by other financial institutions, such as hedge funds or high-frequency trading firms. These tend to have less stringent eligibility requirements than broker-dealer dark pools.
- Broker-Dealer Dark Pools: Broker-dealers such as Goldman Sachs and Morgan Stanley tun these. They typically serve institutional clients and high-net-worth individuals.
- Internalization: Some firms use their own capital to trade with their customers. This type of dark pool is used to reduce market impact. It also provides liquidity and helps to make a profit by capturing the bid-ask spread.
- Electronic Communication Networks (ECN): ECNs are dark pools that display orders electronically and match them internally. They have lower fees than other dark pools and are open to a wider range of traders.
- Liquidity provision pools: Also known as “maker-taker” pools, these pools provide liquidity to market makers. They charge a fee to traders who take liquidity and pay a rebate to those who provide liquidity.
Advantages and Disadvantages of Dark Pools
Now that you have a good understanding of what is a dark pool trade, let’s see its pros and cons.
Advantages of dark pools in trading:
- Reduced Market Impact: Dark pools can help to reduce the market impact of large trades and avoid moving the market against their positions. By executing trades away from public exchanges, investors can avoid the “information leakage” that can occur.
- Anonymity: Dark pools provide anonymity. This can be beneficial for some institutional investors who want to trade without revealing their positions.
Disadvantages of dark pools in trading:
- Lack of Transparency: Dark pools lack transparency and can be difficult for regulators to monitor for possible manipulation or insider trading.
- Limited Access: Retail investors are typically not able to access dark pools, which can lead to a lack of competition and higher trading costs.
- Lack of Liquidity: Some dark pools have less liquidity than public exchanges, which can lead to wider bid-ask spreads and less efficient price discovery.