Dark pools are are effectively private off-market exchanges that enable large or institutional investors to buy or sell large positions without disclosing their intentions to the market. While dark pools can offer price and liquidity opportunities to large investors, they also pose some significant risks. In this article we shed some light on dark pools, exploring the key benefits and considerations associated with these ‘hidden’ exchanges.

Why do dark pools exist?

Dark pools are private exchange-like venues where orders are not displayed. They serve to facilitate block trading on a large scale.

  • Anonymity
    Unlike public exchanges, dark pool participants do not disclose their trading intention to the exchange prior to execution. This helps to protect the anonymity of the investor and limit adverse price movement prior to execution.
  • Lower dealing costs
    Dark pools offer the opportunity to control dealing costs by avoiding exchange fees and offering the opportunity to price at the mid-point of the bid/ask spread rather than paying the full spread. This directly reduces the cost of transacting.
  • Added liquidity
    An added benefit of dark pools is access to liquidity unavailable on public exchanges.

What are the issues associated with dark pools?

While a lack of transparency is part of the appeal of dark pools, this attribute can also make these exchanges vulnerable to potential conflicts of interest by their owners and other predatory trading practices. This can occur if a broker’s proprietary traders trade against dark pool clients or if the broker sells special access to the dark pool to high-frequency trading (HFT) firms.

A number of techniques can be employed to avoid the toxic liquidity of predatory strategies. For example, minimum acceptable quantities (MAQs) can be applied to stipulate dealing in sizes that are too large for an HFT firm’s risk horizon.

Dark pools may also result in a pricing disparity between the private exchanges and the public exchanges. This is because dark pools do not disclose trade details until after the execution is transacted, potentially hindering price discovery.

These factors need to be carefully considered and reviewed when making an informed decision regarding the use of dark pools in the dealing process.

Final thoughts

Dark pools are one of many valuable resources for the institutional investor that should be properly analysed and considered when transacting on behalf of clients. Used properly, dark pools can offer price, cost, and liquidity advantages to the institutional funds that ultimately benefit the retail investors who own these funds.

About the Author

Eric Cadogan, Senior Dealer, Global Equities and Fixed Income, Multi-Asset Group at AMP Capital is responsible for trade execution across global real estate investment trusts, global infrastructure and global resources stocks listed in the Americas, UK and Europe.

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