What Is A Dark Pool?http://www.fool.com/investing/general/2014/06/28/what-is-a-dark-pool.aspx Anna B. Wroblewska
June 28, 2014
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
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?
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
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.
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?
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 i