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

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. 


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.


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.


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. 


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. 

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