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12 Apr 2022

A dark pool is a secure location where financial items can be traded privately. There is no visible order book, and trades are not publicly viewable, unlike a public exchange (or only become visible once they already have been executed). Dark pool liquidity refers to liquidity on dark pool markets. Block transactions account for the majority of dark pool trading. A block trade is a transaction in which a big amount of an asset is sold at a fixed price.

Since their inception in the 1980s, dark pools have primarily been used by institutional investors who trade enormous volumes of securities. Dark pools allow institutions to place orders and trade without first disclosing their intentions to the public. This is a desirable attribute because their plans to buy or sell huge amounts of an asset could jeopardise their trade before they ever get a chance to execute it.

Why use a Dark Pool:

Compare this to today's situation, when an institutional investor can sell a one million share block through a dark pool. The lack of transparency benefits the institutional investor since it may result in a higher realised price than if the sale were made on an exchange. There is no order book visible to the public since dark pool members do not disclose their trade intentions to the exchange before execution. After a wait, trade execution details are released on the consolidated tape.

Because a dark pool is a forum targeted at large investors, the institutional seller has a better chance of finding a bidder for the entire share block. If the transaction is conducted at the midpoint of the quoted bid and ask prices, there is a chance of a price improvement. Of course, this implies that the investor's anticipated sell isn't leaked and that the dark pool isn't exposed to high-frequency trading (HFT) predators who would try to take advantage of the investor's trading intentions.

Advantages of Dark Pool:

  • Decreased impact on market sentiment – Traders who want to trade in huge amounts can keep their plans hidden from the general investing public.
  • Price improvement – The average of the best available bid and ask price is frequently used to match deals. Both the buyer and the seller benefit from a better deal than they would have gotten on the open market.
  • No slippage – Because the majority of dark pool trading is done in block deals at predetermined prices, dealers may be confident that their entire trade will be executed at the intended price.

Controversies of Dark Pools:

Despite the fact that regulated dark pools are lawful and regulated by the SEC, they have been criticised for their lack of transparency. Because dark pool trades are not exposed to the general public, high-frequency trading firms have sometimes utilized them for predatory acts, such as "pinging" dark pools to uncover big secret orders and then engaging in front-running or latency arbitrage.

Dark pool operators have also been accused of misrepresenting their pools to their clients or exploiting their dark pool data to trade against their other customers. Securities regulators have recovered more than $340 million from dark pool operators to settle various litigation charges, according to The Wall Street Journal.

In dark pools, the average trade size has shrunk to around 200 shares. Dark pools and alternative trading systems, according to exchanges like the New York Stock Exchange (NYSE), are losing trading market share to dark pools and alternative trading systems because of the small trade size.

Several crypto exchanges offer dark pool services for large crypto investors.  Crypto exchanges also charge an additional fee for permitting transactions through their dark pool. For example, Kraken charges trading fees for dark pool orders at 0.20% to 0.36%, which is an extra 0.20% compared to normal limit order rates (0% to 0.16%). Dark pool rates on Kraken depend on users' 30-day trading volume (in USD equivalent).

Bottom Line:

Dark pools offer pricing and cost advantages to buy-side organisations like mutual funds and pension funds, with the expectation that these advantages will be passed on to individual investors who own these funds. Dark pools, on the other hand, are vulnerable to conflicts of interest by their owners and exploitative trading activities by HFT businesses due to their lack of transparency. Dark pools have been under increased regulatory scrutiny as a result of the HFT scandal, and the proposed "trade-at" rule could jeopardise their long-term sustainability.

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