What Is A Dark Pool?

Dark pools are in the news and on regulators’ minds. But what is a dark pool, how does it work, and most importantly, what are the risks?

Jun 28, 2014 at 10:00AM

Ripple
Flickr / JohnGoode.

You read the news, and there's all this talk of "dark pools." Well, what on earth is a dark pool?

Imagine you're a major Wall Street titan who everyone pays attention to, like Carl Icahn*.

You want to buy a significant minority stake in a company, and you're all ready to go: You have your valuation numbers, your target holding percentage, and an awesome action plan.  

So, how do you go about buying your shares? 

Well, you could buy them on an exchange. This comes with a risk, however: if anyone gets a whiff of what you're doing you could spark the Icahn Effect (where the price goes up because Carl Icahn is involved) -- meaning you suddenly end up paying a lot more. 

Alternatively, you could go to a dark pool and anonymously state your order and desired price. If another (also anonymous) institution or individual can fill it and wants to, you do. Easy peasy. You get your shares at the price you want, and the market doesn't go into hysterics and mess up your model. 

That, my friends, is the essence of the dark pool.

The Structure of a Dark Pool
Dark pools came into existence mainly for institutional investors wanting to go about their business quietly and without the potential price movement risks that come with buying and selling large blocks of stock. 

Mask

Flickr / afroboof.

Anonymity was a nice part of the deal, and it remains in place today. Trades are reported as over-the-counter transactions with a bare minimum of disclosure, unless legal or other requirements compel someone to share more. 

I know, I know, you're snoring. Seems weird but innocuous and kind of boring, right? 



So What's the Problem?
No one really cared about dark pools until they started gaining popularity, and their growth has been swift in the last few years. Today, these private exchanges are estimated to account for nearly 40% of all stock trades in the US, and the average trade size for the five largest dark pools is a minuscule 187 shares.

So, what started out as a specialty venue for large institutional trades is now... what, exactly? A lot of people to ask precisely this question, and the trouble is that it's difficult to get a handle on what's going on and whether dark pools are affecting the public markets as a whole.  

The key questions: Do dark pools diminish the transparency and validity of prices? Are they subject to manipulation and conflicts of interest? And finally, how does something like a dark pool square with the whole notion of a transparent public marketplace? 

The Basic Conclusions on Pricing
Looking at the academic literature, we can pretty safely conclude that large block orders conducted in the dark don't affect the integrity of the public markets. 

It gets hazier when you start looking at all these smaller trades, which are obviously very common. Unfortunately, there isn't a definitive conclusion on the matter.

Dart

Flickr / 7 bits of truth

One paper from MIT, which models trading behavior, suggests that dark pools should improve price accuracy, but that this might not be the case depending on how traders act in real life. Another, which looked at trading data in Australia, found that low levels of dark pool trading improved price accuracy, but that high levels tended to diminish it.

In other words, we're still not sure. 

A relatively consistent finding, however, is that dark pools tend to segment the market into "informed" traders, who trade on timely information, and "uninformed" traders, who trade on everything else. The idea is that informed traders tend to favor public markets because they need to execute right now, while uninformed traders are attracted to dark pools because they don't. 

A possible result of market segmentation is that bid-ask spreads might widen on the public exchanges. Why? When market-makers deal with a higher proportion informed customers, they might have to widen their spreads in order to continue making a margin. This could lead to a loss of efficiency in the overall market, particularly on an exchange like NASDAQ, where spreads aren't standardized. Again, the evidence is still inconclusive, but there are indications that this could happen.

Is There Room for Manipulation? 
Another major area of concern, which both the SEC and New York Attorney General are knee-deep into, is the potential for manipulation and conflicts of interest.

Hacker

Flickr / Ivan Gomez David Arce.

In fact, the New York Attorney General just filed a lawsuit against Barclays for fraud related to its dark pool, and two years ago the SEC charged another dark pool with misusing participants' confidential information.

I'm sure more is on the way. 

There is increasing scrutiny on dark pools because their operators have insight into what's happening on their exchanges -- the kind of insight that might be very valuable to someone who, for example, wants to get ahead of a major block trade that might affect prices if it were public. 

Transparency: Philosophical Concept or Practical Necessity?
Many of the concerns raised about dark pools are rooted in the concept of transparency. Public markets are based on the idea that information should be, well, public, and that insiders shouldn't have a special advantage over everyone else. 

Magnifying

Flickr / Okko Pykko.

If dark pools harm the overall transparency of the market or profit from their "insider" status, it's an issue that regulators will continue to tackle aggressively. While we're still not 100% sure how much dark pools affect prices, there is certainly room for inefficiency and manipulation. With all the scrutiny, I'm sure we'll be seeing more and more about dark pools coming into the light.  

*Please note: I have no idea whether Carl Icahn trades through dark pools, though I wouldn't be surprised if he did, considering how influential his investment decisions are. 

Bank of America + Apple? This device makes it possible.
Apple recently recruited a secret-development "dream team" to guarantee its newest smart device was kept hidden from the public for as long as possible. But the secret is out, and some early viewers are claiming its destined to change everything from banking to health care. In fact, ABI Research predicts 485 million of this type of device will be sold per year. But one small company makes Apple's gadget possible. And its stock price has nearly unlimited room to run for early in-the-know investors. To be one of them, and see Apple's newest smart gizmo, just click here

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

1 Key Step to Get Rich

Our mission at The Motley Fool is to help the world invest better. Whether that’s helping people overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we can help.

Feb 1, 2016 at 4:54PM

To be perfectly clear, this is not a get-rich action that my Foolish colleagues and I came up with. But we wouldn't argue with the approach.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich" rated The Motley Fool as the #1 place online to get smarter about investing.

"The Motley Fool aims to build a strong investment community, which it does by providing a variety of resources: the website, books, a newspaper column, a radio [show], and [newsletters]," wrote (the clearly insightful and talented) money reporter Kathleen Elkins. "This site has something for every type of investor, from basic lessons for beginners to investing commentary on mutual funds, stock sectors, and value for the more advanced."

Our mission at The Motley Fool is to help the world invest better, so it's nice to receive that kind of recognition. It lets us know we're doing our job.

Whether that's helping the entirely uninitiated overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we want to provide our readers with a boost to the next step on their journey to financial independence.

Articles and beyond

As Business Insider wrote, there are a number of resources available from the Fool for investors of all levels and styles.

In addition to the dozens of free articles we publish every day on our website, I want to highlight two must-see spots in your tour of fool.com.

For the beginning investor

Investing can seem like a Big Deal to those who have yet to buy their first stock. Many investment professionals try to infuse the conversation with jargon in order to deter individual investors from tackling it on their own (and to justify their often sky-high fees).

But the individual investor can beat the market. The real secret to investing is that it doesn't take tons of money, endless hours, or super-secret formulas that only experts possess.

That's why we created a best-selling guide that walks investors-to-be through everything they need to know to get started. And because we're so dedicated to our mission, we've made that available for free.

If you're just starting out (or want to help out someone who is), go to www.fool.com/beginners, drop in your email address, and you'll be able to instantly access the quick-read guide ... for free.

For the listener

Whether it's on the stationary exercise bike or during my daily commute, I spend a lot of time going nowhere. But I've found a way to make that time benefit me.

The Motley Fool offers five podcasts that I refer to as "binge-worthy financial information."

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. It's also featured on several dozen radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable ... and I don't say that simply because the hosts all sit within a Nerf-gun shot of my desk. Rule Breaker Investing and Answers contain timeless advice, so you might want to go back to the beginning with those. The other three take their cues from the market, so you'll want to listen to the most recent first. All are available at www.fool.com/podcasts.

But wait, there's more

The book and the podcasts – both free ... both awesome – also come with an ongoing benefit. If you download the book, or if you enter your email address in the magical box at the podcasts page, you'll get ongoing market coverage sent straight to your inbox.

Investor Insights is valuable and enjoyable coverage of everything from macroeconomic events to investing strategies to our analyst's travels around the world to find the next big thing. Also free.

Get the book. Listen to a podcast. Sign up for Investor Insights. I'm not saying that any of those things will make you rich ... but Business Insider seems to think so.


Compare Brokers