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Trading in the Dark: How Dark Pools Work

Photo courtesy of Peter Sheik via Flickr.

What are dark pools in the world of stock exchange, and are they hurting the market? We take the plunge.

A dark pool is Wall Street slang for a private stock trading platform. It’s referred to as “dark”  due to its lack of visibility in terms of size and price until after the exchange is made. While they definitely aren’t as frightening as deep waters within which mysterious monsters dine on drowned sailors, they may be equally murky.

How do dark pools operate?

As a type of alternative trading system (ATS), dark pools operate by keeping quotations hidden, limiting interaction between participants, as opposed to “lit markets,” which are completely transparent to all investors, public included. Dark pools have little to no government regulation, existing only within the privacy of dark pool networks.

According to CNBC, dark pools were started in order to help institutions hide big orders that might otherwise have their prices driven up by outside traders. In recent years, dark pools have become a subject of concern due to the regulation, amount, and size of these blind trades, and the effect they have on the overall market.

Here are some of the major issues with dark pool finances:

1. Dark pools are rising in popularity

In 2008 they occupied 16 percent of all trading, but have reached as much as 40 percent in 2014. According to the US Securities and Exchange Commission (SEC), this growth increases a lack of transparency that could create a two-tiered market and deprive the public of information about stock prices and liquidity.

2. More trading in the dark means fewer buy and sell orders placed on exchanges,

This can lead to worse prices for stocks, as reported by the Wall Street Journal.

Similar findings have been presented on the World Federation of Exchanges, which calls dark pools’ negative effect on market liquidity “fragmentation.” These findings suggest that off-market exchanges impair the liquidity of lit markets by driving bid prices higher.

3. As most dark pools are operated by big banks, distrust and abuse of customer information is a cause of concern

This is especially true in regard to regulation groups such as The Financial Industry Regulatory Authority (FINRA).

According to the New York Times, 67 percent of long-term investors said that they have “trust issues” with dark pools, from a survey in 2012 by the Tabb Group. FINRA is also concerned banks are improperly sharing customers’ financial trading information, and are investigating 15 of the largest dark pools (there are about 30), according to the investors’ research resource Value Line.

What can be done?

Europe and countries such as Canada and Australia have placed strong regulations on dark pools in their nations by putting caps on the amount, ensuring price improvement, and setting size constraints.  So far, regulations by the SEC and FINRA do not limit the amount of dark pools in the U.S., though they are  audited, registered, and examined, shining light, however limited, into these pools and hopefully not pulling out many bones.

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What are your thoughts on dark pools? Tweet us @curiousmatic. We’d love to hear your thoughts!

Jennifer Markert