Trading in the Dark.

To many of us, this phrase sounds ominous, mysterious, and conceivably illegal. Although high-speed (high- frequency) trading has been getting a lot of attention because it can cause technological malfunctions and trading to be halted altogether, the rise in dark pool trading has received relatively little illumination. Its ascendance, though, is gaining rapidly. Indeed, it is estimated that as much as 40% of stock trades are now executed in dark pools, up from 16%, in 2008.

What is Dark Trading?

Dark trading or dark pool trading is the buying and selling of shares on "off-exchange platforms". Dark Pools are alternative trading systems (ATSs).  It generally involves a stock transaction between a large institutional buyer and seller that is purposely hidden from the general public. Neither the price, the size of the trade, nor the identity of the trading firm, is displayed. The average investor is unlikely to know the trade ever occurred.

What Are the Advantages of Dark Trading?

Anonymity is the main reason it is done. Many banks, broker-dealers, and institutional investors looking to offload unwanted inventory at a decent price will use dark pools to do so. The deal isn’t seen by the public who could, and very likely would, influence a private dark pool bid/offer scenario. The second reason is to lower trading costs. When an institutional investor makes a large block trade on the open market (like the NASDAQ,) , investors will see a spike in volume. This is likely to prompt a change in the price of the stock, which would increase the cost of purchasing that block order. This can translate into a lot of money when millions of shares are passing hands. If, however, market forces are not involved, and only the dark pool buyer and seller are aware of the transaction, both parties can get a price that’s better for both of them. It is also easier and cheaper to divvy up the block into smaller orders for sale to other dark pool participants.

Is It Legal?

Yes. Indeed it has been around for decades, and used to be known as “upstairs trading”. Dark pool trading is just subject to less stringent regulations than public exchanges. Dark pool trades are regulated by the NBBO (National Best Bid and Offer). Prices cannot be chosen arbitrarily, and oftentimes the price is actually the mid-point of the NBBO. A stock cannot trade outside the NBBO without an inter-market public “sweep” satisfying orders on other markets. Many retail investors see this form of trading as making stock trading less transparent, and therefore less efficient. Last Fall, the Canadian government put regulations in place to limit off-exchange trading in that country’s markets. In March, Australia followed suit, citing a report that stated that the cost of trading went up for all traders when more trading occurred in the dark. The SEC in the U.S. has declined to act thus far. Last September, however, FINRA  (Financial Industry Regulatory Authority), began gathering information from 15 of the largest dark pools (there are upwards of 30) and is trying to determine whether participants improperly shared financial trading information about their customers. The SEC has already put in place a regulation requiring ATSs to make information public if more than a certain volume of shares is being bought and sold. 

Why Has It Become So Popular So Quickly?

It has become more common because of the use of increasingly fast computers used for trading. Dark (or off-market) trading permits a sort of “time out”, whereby a stock’s price remains at rest for a short period of time while the appropriate buyer or seller can be found. Too, dark pool investors say they have moved more of their trading into the dark because they have grown more distrustful of public exchanges due to rising technological mishaps arising from an increasing number of high-frequency trades. Another reason is the ongoing general decline in stock price volatility. Calmer trading favors dark trading. There is more time to make the transaction with the assistance of computer algorithms to match orders more efficiently. In many instances, for a dark pool trade to take place, a buyer has to be present before a seller can initiate a sale. This is called iceberg trading. The “iceberg” being the buyer. Sometimes, however, a seller doesn’t emerge to consummate the transaction at the same time a buyer is floating by. This is called “ships passing in the night”. Finally, with the recent revival of interest in the stock market among ordinary investors, a form of dark trading called “internalization” has emerged. This is the practice whereby a handful of firms like Citigroup (C) and Knight Capital (KCG) are stealing business from stock exchanges. They pay retail brokers like TD Ameritrade (AMTD) and Scottrade for the opportunity to trade with their retail clients before those accounts go to an exchange to make a transaction.

What Are The Disadvantages For Dark Pool Participants?

There are very few. If a non-dark pool trader becomes aware of a block of shares waiting to be bought in a dark pool (an iceberg), he or she can take advantage of the price it is waiting to be bought for by pre-emptively acting upon this information, thereby effectively “sabotaging” a dark pool buyer’s advantage because it is made public. In the trade, this is referred to as “gaming”. 

Types of Dark Pools And Their Participants

Independent Dark Pools. There are about eight to ten of these. Examples include Instinet, RiverCross, Liquidnet, and SmartPool.

Broker-dealer owned pools. These are the most common, of which there are around 20. Some of the most active are CrossFinder owned by Credit Suisse, LX Liquidity Cross (Barclays Capital), GETMatched (GETCO), Nomura NX (Nomura), and SIGMA X (Goldman Sachs).

Consortium-owned pools. There are only two. BIDS ATS (BIDS Trading), and Level ATS.

Exchange-owned pools (around six). Examples are International Securities Exchange, and NYSE Euronext.

Other pools are Chi-X, and Turquoise.

The Bottom Line for Investors.

All told, markets cannot be efficient if many orders never see the light of day. An inefficient market is not fair to the average investor, nor is it stable. Furthermore, potential interaction between these minimally regulated, off-exchange venues and the high-speed, computer-driven trading platforms that now dominate the market is cause for concern. A rising number of retail investors (and many institutional investors) are becoming skeptical that the price of a security they see displayed on a public market forum like The NYSE is the correct one. This is particularly the case with a stock that is heavily owned by institutions. This is just another way of making trading more difficult for the individual investor.  Another major problem is that financial trading software programs are being written to limit pre-trade (public) noise, by only allowing dark pool participants to see buy and sell orders that match what they are looking for. This means that rather than soliciting bids, the software is excluding potential buyers/sellers.  Lastly, management fees at mutual funds are rising as portfolio managers are having to spend more time and money navigating dark pools in order to try and buy and sell stock at beneficial price points. 

When trading an equity for their own accounts, individual investors should be aware of the possibility, actually the probability, that dark trading in that security is occurring, and act accordingly.

At the time of this article’s writing, the author did not hold positions in any of the companies mentioned.