Why Is Dark Pool Trading Legal

Dark liquidity pools offer institutional investors many of the efficiencies associated with trading on stock exchanges` public limit order books, but without showing others their shares. Dark liquidity pools avoid this risk because neither the price nor the identity of the trading company is displayed. [10] Dark pools are a controversial topic, especially after the events of the meme stock phenomenon in 2021. However, the truth is that most retail investors don`t have to worry about dark pools. Dark pools exist primarily to save small amounts of money and fees for institutional traders, and they are regulated and closely monitored by the SEC. Because of their sinister name and lack of transparency, dark pools are often seen by the public as dubious companies. In reality, dark pools are strictly regulated by the SEC. However, there is concern that, due to the sheer volume of black market trading, the public values of some securities may become increasingly unreliable or inaccurate. There is also growing concern that dark pool exchanges provide excellent fodder for high-frequency predatory trading. Dark pools are most favorable for institutional investors who execute block trades – perhaps when they take a very large position in an investment.

Since the introduction of dark pools, institutional investors and funds have been able to easily postpone orders for large blocks. As a result, impacts on markets and prices are avoided. Now there are over fifty dark pools registered with the U.S. Securities and Exchange Commission. Dark pool trading is different from being a market maker. One of the main advantages for institutional investors of using dark pools is to buy or sell large blocks of securities without showing a hand to others, thus avoiding market effects because neither the size of the transaction nor the identity are disclosed until some time after the transaction has been occupied. However, it also means that some market participants are at a disadvantage because they cannot see orders before they are executed; Prices are agreed by participants in dark pools, so the market is no longer transparent. [3] Dark pools are sometimes portrayed in an unfavorable light, but they serve a purpose by enabling large transactions without affecting the wider market. However, their lack of transparency makes them vulnerable to potential conflicts of interest from their owners and predatory trading practices from some high-frequency traders. Gensler, who joined Twitter last week, also responded to followers who, like many traders on Reddit, have raised particular concerns about “dark pools,” which are private exchanges that institutional investors use to execute trades anonymously. Dark pools are considered legal. However, the system is criticized for its lack of transparency in business transactions.

Prices traded on dark pools may differ from those on public exchanges, which could be inconvenient for retail investors. The main objective of dark pools is to generate liquidity, mainly for the benefit of buy-side institutions, without significantly disrupting asset prices. High-frequency, high-volume traders can take advantage of dark pools because they need to move quickly through the market. Another type of adverse selection is caused in the very short term by the economy of dark pools compared to the markets indicated. If a buy-side institution adds liquidity to the open market, an ancillary office of a bank may want to take that liquidity because it has short-term needs. The prop desk would have to pay an exchange/ECN access fee to withdraw liquidity from the indicated market. On the other hand, if the buy-side institution were to float its order in the dark pool of the prop desk broker, then economics makes it very favorable for the prop desk: they pay little or no access fee to access their own dark pool, and the parent broker receives tape revenue to print trades on an exchange. For this reason, it is recommended that companies that do business in smaller sizes and do not have short-term alpha do not add liquidity to dark pools.

Instead, go to the open market, where short-term adverse selection is likely to be less severe. [ref. needed] Prices are derived from incoming orders and order flow. This gives the clients of these brokers access to dark pools. Dark pools appeared in the late 1980s. It is estimated that it will account for about 40% of all U.S. equity transactions in 2017, compared to about 16% in 2010. The FCA also estimates that dark pools accounted for 15% of US volume in 2014. A third use is for high-frequency trading transactions. These funds make money by capitalizing on arbitrage strategies or tiny price movements on many different stocks. Their strategies are based on trading at the absolute lowest fees.

Dark pools help make these approaches more convenient. Finally, and more controversially, dark pools can be used to route transactions between wholesalers in pay-to-order systems, as described above. These aren`t all possible uses for dark pools, but these four cover a wide range of what dark pools can achieve for their customers. The use of dark pools for trading has also sparked controversy and regulatory action, in part due to their opaque nature and conflicts of interest between the dark pool operator and participants, a topic that was the focus of Flash Boys, a non-fiction book on high-frequency trading (HFT) in financial markets published by Michael Lewis in 2014. [4] [18] [19] [20] [21] These dark pools are set up by stock exchanges and public agencies. They grant their clients the advantages of anonymity and secrecy in the execution of their orders. If it is an asset that can only be traded on an exchange, it is generally assumed that the standard pricing process ensures that the price is approximately “correct” or “fair” at any given time. However, very few assets fall into this category, as most can be traded off-market without printing the transaction to a publicly available data source. As the proportion of the daily volume of assets traded in this hidden manner increases, the public price could still be considered fair. However, if public trading continues to decline as secret trading increases, it can be noted that the public price does not take into account all the information about the asset (in particular, does not take into account what has been traded but hidden) and therefore the public price may no longer be “fair”. [ref. needed] The new regulation allowed the emergence of dark pools in the 1980s, allowing investors to trade large block orders while avoiding market effects and forgoing privacy.

In 1986, Instinet launched the first dark pool trading platform called “After Hours Cross”. However, it was not until the following year that ITG created the first intraday dark pool “POSIT”, both of which allowed large trades to be executed anonymously, which was attractive to sellers of large blocks of shares. Over the next 20 years, trades executed on dark pools accounted for a small fraction of the market, between 3 and 5% of all trades. This was sometimes called “upstairs trading.” [9] Gensler pointed out that dark pools have become increasingly common during the recent wave of retail investors, doubling the SEC`s role in “protecting against fraud and manipulation, and whether or not it comes from large players and hedge funds in the market.” There is a lot of criticism of HFT because it gives some investors an edge that other investors cannot, especially on private exchanges. Conflicts of interest and other unethical investment practices can also be hidden in obscure pools. Dark pools are operated by private brokers that are subject to fewer regulatory and public disclosure requirements than public exchanges. [14] Tabb Group estimates that dark pool trading accounted for 32% of transactions in 2012, compared to 26% in 2008. [14] Since dark pools offer complete secrecy and anonymity, the public will have no idea what the major institutions are doing. As a result, it is an advantage for big players, but unfair for other investors and traders.

This particular advantage puts all other market participants in a vulnerable position. They have no idea what is being done in the markets by the big players. Because dark pools operate with very little oversight, they are rigorously scrutinized because they don`t introduce as much regulation as other public exchanges.