This refers to a private forum designed for trade securities where investors have the chance of placing big orders and completing trades without the need of publicly advertising one’s intention.
Also referred to as dark pool of liquidity, they are utilized by investors for block trading especially where a large number of financial instruments are involved.
Dark pools have been named so because of their lack of transparency. They were established by institutional investors with the intention of not impacting the market thanks to large orders and adverse prices whether it be for stocks or other financial instruments.
Purpose of a Dark Pool
What you need to know is that dark pools are used in order to provide investors and traders with a system where their orders are filled according to the rules set down in the National Best Bid and Offer. If you are not familiar with the National Best Bid Offer, it simply refers to a rule set by the SEC that helps to define the best current bid and offer price provided at the exchange.
As said earlier, dark pools are utilized by institutional traders in order to fill their large orders thus preventing any massive changes in the market. This means that institutional traders are able to trade large blocks of financial securities since the transaction is processed privately.
A desirable price is always achieved through private processing eliminating the worry that an institutional trader will have to pay a premium price.
For example, a particular investment firm is planning to purchase 2 million shares of a company. If it were completed via the normal channel, the results would affect the market.
Types of dark pools
What you ought to know is that there are over 40 dark pools available as of May 2017. These have been registered with the SEC so you are assured of best practices. Here are the three categories:
- Electronic market makers – This is offered by Getco and Knight. As the principals, their transaction prices are usually not calculated according to the NBBO which means there is price discovery.
- Broker dealer – They are usually set up by institutional broker dealer for their clients. Under this type of dark pool, prices are derived from the order flow which means an element of price discovery is within. Some of the principals include Goldman Sachs Sigma X, Citi’s Citi Match and Morgan Stanley’s MS Pool.
- Agency broker – They are designed to act as agents which means their prices are retrieved from exchanges so no price discovery. Some of the agents include Instinet, ITG Posit ad Liquidnet among others. There are exchange owned dark pools under this category and they are run by BATs trading and NYSE Euronext.
Dark Pool Advantages
Dark pools have the following advantages to the users;
- i. They help to lower market impact since the large orders are processed privately
- ii. Large institutional traders experience reduced transaction charges. This is because no exchange fees are paid.
If you are a large institutional trader, you can save a lot when you opt to transact privately via a dark pool of your own choosing. Furthermore, traders are able to reduce impact on the market.
Despite these benefits, traders may be susceptible to conflicts of interest. This is attributed to lack of transparency. The good news is that they are tightly regulated by the SEC.