The nature of the game as it is played is such that the public should realize that the truth cannot be told by the few who know — Reminisces of A Stock Operator by Edwin Lefèvre

Anybody who has been to any kind of betting venue i.e. a horse race, a casino or even online betting understands information asymmetry and control of emotions. Both of these define what is known as “Risk Intelligence” or making better estimates of probability than the average Joe. Daniel Kahneman and Amos Tversky have dedicated a large body of work to human decision making. They found out, not surprisingly, that most of us are bad at predicting probabilities. Now, think of a similar situation where institutional investors offload millions of shares on a public exchange and the volatility that those trades would create. Combine that with limited self control and limited ability to forecast odds and you realize the need for an alternate market system. Dark Pools are one such alternative platform. Today, there are roughly 40 dark pools in the US which account for 15% of equity trading.This article provides a basic understanding of dark pools for educational purposes only.

The word ‘Dark Pools’ conjure images of nefarious activities. In truth, the word ‘Dark’ is used to signal the limited visibility into the dealings of ‘Dark Pools’. A Dark Pool is an alternate private market to the public stock exchanges like NYSE, NASDAQ and so on. It is primarily useful to institutional investors to put block trades and to discover a better price for their trades. They are exclusive clubs and private trading platforms.

The Need For Dark Pools

The very first stock exchange in Asia was the Bombay Stock Exchange (BSE) which was established in 1875. It slowly moved from being a gathering of traders under a Banyan tree to an open outcry exchange floor where brokers (licensed dealers) would call out their orders. Also called the bullpen, the open outcry trading floor exists even today at the New York Stock Exchange (NYSE). In 1995, BSE introduced an electronic system called the Bombay Online Trading (BOLT) System. Similarly , the very first dark pool in the world actually emerged as an electronic exchange which offered an alternative to the open outcry system. Institutional Network (Instinet)

Three primary reasons to operate dark pools are:

1. Better price discovery for traders on such exchanges. Dark pools generally follow the National Best Bid and Offer (NBBO) regulation defined by the US Securities and Exchange commission as the best price available for a traded security.

2. Keeping block trades (large orders) alway from public stock exchanges to avoid volatility in the public stock exchanges such as the NYSE and to offer secrecy to traders in the dark pool.

3. Increased possibility of finding buyers for huge orders (eg 1 million shares and above).

Dark pools are also venues for after exchange hours trading. Many exchanges have a fixed time for trading in stocks. However, dark pools do not suffer from such limitations.

Types of Dark Pools

Generally speaking, dark pools are not available to the retail investor except indirectly through a broker.

Independently Owned

Independent Dark Pools are Owned and operated by independent companies. Example includes Instinet.

Broker Dealer Owned

Broker dealers also operate their own dark pools. Entities with a broker dealer licenses including banks and financial services giants such as Barclays, Credit Suisse and JP Morgan are examples of broker dealers who own and operate dark pools.

Exchange Owned

Popular stock exchanges could own and operate their own dark pools. As demand for alternative markets such as markets which allow companies to remain private longer (NASDAQ Private Markets) increases, the need to operate such exchanges also increases. Examples include NYSE Euronext and BATS Trading.

The advantages of dark pools also make them susceptible to predatory trades by High Frequency Trading (HFT) systems. HFT systems use algorithms to execute trades in milliseconds.

Dark pools are constantly under the scanner of European regulations such as MiFiD ii and regulators such as the SEC.

Crypto Dark Pools

Trading in Bitcoin and cryptocurrencies lends itself to dark pool trading perfectly. The San Francisco based exchange Kraken was the first to offer dark pool trading in cryptos as early as 2015. Broker dealer TradeZero and Bitfinex are other trading venues.

Republic Protocol raised $33.8 million from crypto hedge funds to create the first decentralized dark pool for trading bitcoin, Ether and ERC2.0 tokens.

Ping Pools

Ping Pools have emerged as an exclusive VIP club of traders. Unlike dark pools, ‘ping’ pools have one counterparty ie the operator of the ping pool. A client, through a broker, pings the private dark pool to execute an order at a given price. The operator then uses its own money to either fulfill the trade or reject it. Ping pools account for less than 3%of equity trades today.

Parting Thoughts

The story of financial innovation, like most inventions, is a story of need.There are incredible changes in the world of finance today in terms of products (digital currencies, derivatives etc.), and platforms (Dark Pools, Ping Pools, Robo Advising etc).

Financial innovation arises more often than not because of one and one reason only: helping money make more money. Technology has stretched the possibilities to micro second high frequency trading, algorithmic trading and Blockchain based hedge funds that pool different models from data scientists across the world. Sometimes High Frequency Trading (HFT) acts as a detriment to the operation of dark pools.

Recently, the venture capital arm of Steve Cohen’s firm Point 72 Asset Management LP announced its backing of Imperative Execution Inc. which is a startup with the technology to prevent High Frequency Traders (HFT’s) from taking away the profits from stock pickers. Imperative has created a platform that protects dark pools from predatory trades by HFT traders.

Dark pools come with a lot of dangers and perils. The inherent nature of these opaque markets makes them very risky and therefore closed to retail investors. Regulators are constantly watching these trading venues and taking action against nefarious players.

At the end, you might ask: what do these sophisticated trading platforms and products have to do with a simple retail investor like moi? Turns out, some of these technologies could be democratized to be available to the common man. Until then, be amazed by human ingenuity even if it doesn’t affect you directly because knowing is opening your eyes to a different world.

Recommended Reading:

1. Flash Boys by Michael Lewis
2. Dark Pools: The Rise of The Machine Traders and The Rigging of The US Stock Market by Scott Patterson
3. The Speed Traders by Edgar Perez
4. Shedding light on Dark Pools by the US Securities and Exchange Commission (SEC)