Introduction to Dark Pools

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What are “Dark Pools”?

“Dark pools” or “Dark pools of liquidity,” popularized by Michael Lewis’ 2014 book “Flash Boys,” are private trading platforms that provide a platform for the anonymous trading of securities. In contrast to public exchanges such as the New York Stock Exchange (NYSE), dark pools are primarily used by institutional investors who wish to trade large blocks of securities without impacting the market and creating large price swings. While dark pools have less transparency than public exchanges and can carry additional costs, including potential conflicts of interest and predatory trading from High-Frequency Traders (HFT), many believe they have contributed to market innovations, competition, and reduced execution costs. However, others, including market regulators, are concerned about the effect of dark pool trading on transparency and the quality of price discovery.

When did dark pools arise, and how much trading occurs in them?

The modernization of trading has been occurring since the 1960s, but all-electronic equity trading platforms didn’t arise until the 1990s, fueled by low-cost computer hardware and the internet. Automated trading followed shortly after in 2001, coupled with legislation that mandated decimalized incremented prices rather than fractions. In 2007, Regulation NMS required that stocks be traded on the market with the best price.

Non-exchange trading in the U.S. has surged in recent years, accounting for about 40% of all U.S. stock trades in 2014, compared with 16% six years earlier. Dark pools have been at the forefront of this trend towards off-exchange trading, accounting for 15% of U.S. volume as of 2014, according to figures given by industry insiders. More recently, it is estimated that asset managers execute as much as 30% of their trading volume using dark pools.

Why do investors trade in dark pools?

Consider the following hypothetical case of an investor who has a million shares of a NYSE stock to sell and does not want to use a dark pool. The investor may work with a brokerage firm and floor trader and hope for a decent Volume Weighted Average Price (VWAP) over the course of the day, or break it into smaller amounts and hope to find a large buyer willing to complete the rest of the order. In either case, the order may cause the stock price to fall as other traders realize the influx of supply.

Alternatively, if the investor uses a dark pool to sell the million shares, the lack of transparency may work in the investor’s favor, since they do not show their position as a seller and thus avoid a market impact. Note that as dark pool participants do not disclose their trading intention to the exchange before execution, there is no order book visible to the public. Trade execution details are only released to the consolidated tape after a delay.

What are the types of dark pools?

  • Broker-dealer Owned: These dark pools are set up by large broker-dealers for their clients and may also include their own proprietary trading. They offer price improvement according to the National Best Bid and Offer (NBBO) regulation and typically trade directly with other large broker-dealers.
  • Exchanged-Owned: The dark pools provide access to retail traders and are open to high-frequency trading. NYSE Euronext and BATS Trading are both examples of this type of dark pool.
  • Independent: These are dark pools offered by independent operators like Instinet, ITG, and Smartpool.

Advantages of Dark Pools

With the increase of competition away from the traditional exchanges, there are a couple of advantages to market participants.

Reduced market impact. As noted earlier, the biggest advantage of dark pools is that market impact is significantly reduced for large orders.

Lower transaction costs. Transaction costs may be lower since dark pool trades do not have to pay exchange fees and transactions are executed under the ideals set forth by the NBBO regulation.

Disadvantages of Dark Pools

Market fragmentation is not without downsides. There are three primary issues with dark pool trading.

Exchange prices may not reflect the current market. With dark pools delaying the reporting of trades and prices, public exchanges may have outdated information. For example, if an investor who has been a vocal proponent of a stock sells a large portion of their position in a dark pool, the investor may get a good price, but another investor may have just bought a position through an exchange before the market has had an opportunity to adjust to the news of the vocal investor selling.

Dark pool participants may not get the best price. While the pools should work under the NBBO regulation, the lack of transparency can lead to potential market manipulation by participants and the unethical use of HFT strategies. In 2016, a large firm paid $70 million in fines for misleading investors and overriding their dark pool’s surveillance tools.

The issue of vulnerability to predatory trading by HFTs. As written by Michael Lewis, some HFT firms will employ a tactic known as “pinging” to find large orders hidden in dark pools. They will then use this knowledge to front-run (i.e. buying stock knowing a large order is in the marketplace which could drive the price higher) or latency arbitrage (using sophisticated computer and communication systems to cut down on order transmission times to create a trading edge).

Do we need dark pools?

While we have talked about the advantage of dark pools being largely for institutional investors and large order, the average trade size in dark pools has declined to only about 200 shares. Exchanges like the NYSE, as they fight to stem market share loss, cite this as a reason that dark pools are not as compelling as they once were.

In addition, regulators continue to look at dark pools. With the implementation of MiFID II in Europe earlier this year (more to come on this topic in later blogs), the EU is pushing for more transparency and for more activity to take place on public exchanges. The full impact of these regulations is still being understood, but for now dark pools continue to thrive.


Ultimately, dark pools are one more venue for investors to execute trades and remain an important part of the financial industry. While the question of dark pools and where a company’s stock is being traded may not come up as an Investor Relations issue, Gilmartin Group can help you understand this mechanism and keep you educated on the trading landscape. For more information on dark pools and other parts of Wall Street, contact us.

Ben Milner, Analyst

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