Dark Pools

Dark pools, in finance, are trading platforms which operate outside of the regulated stock market. According to the CFA Institute, dark pools currently account for more than a tenth of total stock trading volume.

A 2014 study conducted by the US financial regulatory authority FINRA labeled Swiss bank Credit Suisse as the world’s biggest dark pool, based on its trade volume. Other major banks like UBS, Goldman Sachs and Deutsche Bank are also active in the dark pool industry.

But how is trading in the murky world of dark pools any different to trading on regulated markets? Why is this form of capital investment becoming increasingly popular among brokers and investors?

The regulated stock market is transparent so far as supply and demand, volume and limits. Rates adapt in relation to supply and demand. If an investor puts a large volume of securities up for sale, the increased supply will often result in the price of those securities dropping as the trade is executed. This results in the seller receiving a lower price per security than the original price at the time the order was placed would indicate. On the other hand, a large buy order for shares in a stock may result in the price of the stock climbing as the order is being filled, resulting in the buyer paying more than the original purchase price.

In a dark pool both the number of participating investors and supply and demand ratios of securities are not disclosed. If a trader wants to buy a specific number of securities from another trader, a dark pool will not allow them to see if the stocks in question are up for sale, or at what price. A transaction will only be performed once the dark pool administrators have found both a buyer and a seller for a set of securities. The price used in the transaction will usually be the average between the highest bid price and the lowest ask price.

The anonymity principle employed by dark pools ensures that aside from the buyer and seller, no other traders are privy to any information related to any transaction. This discretion can make a decisive difference in the prices paid for securities, particularly where very large sales of stocks are concerned. The lower transaction costs compared to public exchanges can be an additional benefit of dark pools. Dark pool providers also advertise the absence of high-frequency traders as a benefit.

But the apparent anonymity of dark pools and their lack of transparency can also present a drawback. Because trading is not regulated, trades made using dark pools are more susceptible to irregularities. There are also strong indications that numerous high-frequency traders engage in dark pools and profit off clueless participants.

Because of these concerns, dark pools are currently being subjected to tighter regulations. The European Union imposed stricter regulations in its upgraded Mifid II guideline – largely as a means of regulating dark pools. But because of the unique advantages of dark pools, demand remains strong in spite of regulations.

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Expert Benjamin Manz
Benjamin Manz is CEO of moneyland.ch and an independent expert on banking and finance.