Can You Swim in a Dark Pool?

One of the hot market topics in recent years is dark pools, a type of alternative trading system (ATS) that was designed, in general, to handle large trades for institutional investors anonymously.

And while there has been a lot discussion about dark pools in the media and elsewhere, it can still be difficult to understand just what a dark pool is and why such venues exist. Let’s shed some light into the darkness.

What is a dark pool?

A dark pool is one kind of ATS in a market for non-exchange trading platforms that has grown significantly over the past 20 or so years.

Also known as “dark pools of liquidity,” dark pools were originally designed to accommodate large buyers and sellers ready and willing to trade large blocks of shares without causing the market to move against them. The idea was this liquidity can provide smoother trading and mitigate large price swings or market dislocation.

They are called “dark” because information about orders placed on the platforms is not published the way it is for order placed on traditional public stock exchanges. Dark pools don’t broadcast pre-trade data — i.e., the presence, price and amount of buy and sell orders — the way that traditional exchanges do. They do, however, need to report information about trades that occur. As a result, dark pools do not contribute to the public “price discovery” process until after trades are executed.

While dark pools only recently became the subject of widespread popular media discussion and reporting, they are not new. The concept of crossing trades off exchange has been around nearly as long as stock exchanges themselves.

In the past, such trades would take place at a broker-dealer’s trading desk, away from the market floor. (Historically, these desks were upstairs above the trading floor, which is why off exchange or block trading is sometimes referred to as “upstairs” trading.”) But dark pools took off as an alternative to exchange trading beginning in the late 1990s, as trading technology and regulation evolved.

Currently, there are about three dozen such venues. Those trading platforms in the third quarter hosted the buying and selling of 70.45 billion shares of stock, up from 59.93 billion shares during the second quarter, according to reporting data compiled by the Financial Industry Regulatory Authority, which began disseminating data on ATS trades in 2014.

What purpose do they serve?

In theory, a dark pool allows an institutional investor — an organization that invests large pools of money, including insurance companies, mutual funds and pension funds—and others to execute large orders without triggering significant moves in the prices of the stocks they are buying or selling.

If an institutional investor wanted to sell 500,000 shares on a traditional exchange, they would likely have to do so in a series of smaller trades, and sometimes over a number of days. This downward pressure could lead to a decline in the company’s stock price as it became apparent that a large seller was in the market.

With a dark pool, there is no publicly available order book, so buyers and sellers have a better chance of completing an entire, larger trade without triggering a price move, perhaps allowing the large investor to walk away with more cash from a sale or a lower total cost for purchases.

Generally, that can be seen as a good thing for the large institutional investors trade on behalf of their clients — those that invest in their investment funds — and potentially for market efficiency overall.

What are the chief concerns?

One concern is that when large orders take place off traditional exchanges, the price of shares simultaneously traded on the open market may not accurately reflect market supply and demand. So, as noted above, these dark pools may not be contributing to price discovery in the same way that traditional exchanges contribute.

At the same time, because dark pools necessarily rely on public prices as a benchmark for their trades, and generally under the SEC’s order protection rule must execute trades at prices at least as good as the best that are publicly available, dark pools benefit from the pre-trade pricing information provided by those exchanges.

Moreover, because dark pools generally are not required to publish detailed information about how their trading platforms work the way exchanges must, some market participants are concerned that less transparent venues may be vulnerable to abuse by their owners, traders with more powerful, faster trading technology, or both.

What are regulators doing?

Given those concerns, it’s natural to wonder what regulators are doing to protect investors of all sizes. Both the U.S. Securities and Exchange Commission and FINRA are actively involved in ATS regulation..

One notable FINRA initiative, approved by the SEC in 2014, involves the publication of ATS trading data. As a result, FINRA makes weekly trading information for each equity ATS, on a security-by-security basis, publicly available on its website after a two-week to four-week delay, depending on the type of stock, in a step to enhance transparency in that market.

Market participants, investors, regulators and academics are now able to see with unprecedented granularity volume information and trends in dark pool trading on a stock-by-stock basis. The hope is that better data will help firms refine their trade routing strategies to reduce costs, enhance market transparency and generally improve trading quality.

In October, FINRA received SEC approval to further expand the transparency initiative by similarly publishing the remaining equity trading volume executed off traditional exchanges, which includes another 15 percent or so of industry trading activity. That trading is known broadly as over-the-counter, or OTC.

Additionally, the SEC recently proposed significant enhancements to its set of rules that governs ATSs. The SEC’s proposal would, among other things, require most dark pools to publicly disclose significant details about the nature of their trading operations, as well as the business activities of the broker-dealer firms that operate the dark pools.

A stated purpose of the SEC proposal is to make these trading venues more transparent so that market participants could make better informed decisions about where they send their orders. As several SEC commissioners noted when they voted in favor of the proposal, increased transparency could help mitigate the various conflicts that have been highlighted in recent SEC enforcement actions involving ATSs.

Another recent SEC initiative may also impact how ATSs operate. In May, the SEC will begin the “tick size pilot,” a two-year pilot program in certain batches of test group stocks of small companies. That pilot will in part test the so-called trade-at rule, which requires that stocks traded in dark pools be sold at a meaningfully better price than what is available on public markets, known as the national best bid and offer.

These are just some of the regulatory efforts that have been highlighted recently. Ultimately, the structure of U.S. equities markets is complex and dynamic and requires evolving regulation. Many market structure questions, including the role and regulation of dark pools, are currently being discussed by an Equity Market Structure Advisory Committee that the SEC formed last year. The Committee includes the CEO of FINRA, along with a mix of industry participants and academics.