Although the name sounds like something out of science fiction, ‘dark pools’ are simply non-public securities exchanges. That said, dark pools have quite a bad reputation due to a lack of transparency and because many believe they allow institutional investors to manipulate the market, undermining trust in public investing. Today, we will explore dark pools, how they relate to institutional investing, and how retail investors can monitor their activities.
What is institutional investing?
What is an institutional investor?
On the other hand, retail investors invest their own money directly or through a broker. Retail investors are considered less successful than their institutional rivals because they have limited funds and lack access to sophisticated tools and knowledge.
Institutional investors account for over 90% of the total stock trading volume. Furthermore, they enjoy less strict regulation, can invest in private equity, such as pre-IPO stocks, and can trade on exclusive private markets called dark pools, which we’ll discuss in detail in this article.
What is the role of institutional investors in the financial market?
Institutional investing works similarly to regular investing, the principal difference being that institutions invest on behalf of others. That said, the sheer scale and sophistication of institutional investing in practice makes it different in several ways.
To begin with, institutional investors trade stocks on a much larger scale, buying ten to hundred times more shares in batches than retail traders. The size of such trade blocks affects the broader market: when institutions buy, the stock price falls; when they sell, the market value plummets.
In short, whether they base their trades on insider information or complex and sophisticated research methods, or they just want to dodge the market fallout of massive trades, institutional investors frequently opt for trading on non-public exchanges called dark pools.
What are dark pools?
The definition of dark pools
Dark pools started forming in the 1980s after U.S. regulations allowed trading securities off exchanges. Today, a significant portion of stock trading volume goes through dark pools. According to some research, dark pools accounted for 13.75% of the equity volume in the U.S. in December 2022.
These private exchanges are called ‘dark’ because they lack transparency. Since transactions on dark pools remain secret until they are fully executed, they do not impact the broader market. However, this lack of transparency leaves them susceptible to a potential conflict of interest and malevolent practices.
What is the purpose of dark pools?
For example, an institutional investor who wants to sell 50,000 company shares via a public stock exchange has several options, such as:
- Execute the order within a day or two, suffering significant value loss;
- Split the order into several parts and sell one part per day, which takes time and also reduces stock price;
- Sell individual shares until a willing buyer offers to buy the whole load at the designated price, which can take significant time even if such a buyer is on the market.
Using a dark pool effectively negates all aforementioned drawbacks as a non-public exchange mitigates the effects on the market, allowing for a quick transaction without adverse market effects.
That said, the lack of transparency has drawbacks, as dark pools remain vulnerable to predatory practices such as high-frequency front-running traders or information leakage.
Pros and cons of dark pools for institutional investors
As we have said, dark pools have both advantages and disadvantages for institutional investors. Let’s sum them up:
Pros
- Legality. Dark pools are legal. Although they lack transparency, they are still regulated by the U.S. Securities and Exchange Commission (SEC);
- Lower costs. Due to bypassing exchanges and their fees, dark pools tend to have lower fees and costs of transactions;
- Lowered market impact. As the public is not informed about the transaction until some time after it was made, the transaction has a much lower market impact in a dark pool when compared to a public stock exchange;
- Better price for block trades. Dark pools are private exchanges designed for institutional investors. As such, institutions can usually find better prices for bulk orders than on public exchanges.
Cons
- Lack of transparency. Although institutional investors pursue dark pools for their secrecy, the lack of transparency causes significant controversy. As the market does not inform the price in dark pools, investors risk reduced profitability on their transactions;
- Predatory practices. Opaque dealings are fertile ground for malevolent practices. Dark pool operators have often been accused of selling information to high-frequency traders and conflict of interest;
- Not available to the public. Dark pools are notoriously exclusive, declining access to retail traders and the larger investing public;
- Regulation. Due to mounting criticism and market manipulation allegations, dark pools are at risk of changing legislation.
Can retail investors use dark pools?
Unfortunately, dark pools are restricted to institutional investors. In fact, one of the main reasons for dark pools is to prevent the public from learning about institutional block transactions. They allow big players to make trades without the hurdles of public competition.
However, dark pools are still regulated; despite the efforts of non-public trading forums, some information is still available to retail trades.
Where to see dark pool trades?
Fully monitoring dark pools is impossible, but some information about over-the-counter trades can still be extracted from their data. Here are the methods available to retail investors:
- Dark pool data providers. Several financial data platforms, such as FINRA’s Trade Reporting and Compliance Engine (TRACE), provide data on non-public exchanges. You can access these reports to learn about the total volume and listed securities on dark pools;
- Market data platforms. Certain specialized services, such as Bloomberg and Trade Alert, offer some analytics and metrics on dark pools, including volume, average prices, and other relevant information. However, most of these are based on a monthly subscription;
- Trading volume spikes. Trades made in dark pools eventually have to leave a mark on public exchanges, especially if they are block trades (more than 10,000 shares). Check for unusual volume spikes to discover when large institutional trades might take place;
- Alternative Trading Systems (ATS). The SEC requires Alternative Trading Systems, which include many dark pools, to report some trade data. Although this data is not real-time, it can provide insights into institutional trading activity.
The bottom line
So, dark pools are private exchanges that allow institutional investors to mitigate the negative market effects of large block transactions, usually at the expense of retail traders and the broader public.
However, you can still peer into dark pool trading with specific services and methods. For better institutional investing tracking, we recommend Finbold Signals. Our service will deliver relevant data and hot reports in the shortest possible time for you to inform your trade and leverage some of the sophisticated methods and approaches of institutional giants.
Disclaimer: The content on this site should not be considered investment advice. Investing is speculative. When investing, your capital is at risk.
FAQs about dark pools
What is an institutional investor?
Institutional investor is a company or organization that pools funds and invests that money on behalf of other people in various assets and financial instruments, including stocks, bonds, real estate, and others.
What are dark pools?
Dark pools are non-public financial exchanges where institutional investors can trade large amounts of securities anonymously without impacting the broader market.
Can I trade on dark pools?
You cannot trade via dark pools unless you are an institutional investor.
Do dark pools affect stock prices?
Dark pools are designed to eliminate or minimize the effect of institutional trading on stock prices.
Do dark pools enhance or reduce capital market efficiency?
Yes, dark pools are frequently under fire due to market manipulation and reduced capital market efficiency.
What are the disadvantages of dark pools?
Some of the main disadvantages of dark pools include lack of transparency, risk of predatory practices, and institutional exclusivity.
What is the difference between dark pools and OTC?
The primary difference between dark pools and OTC is the fact that dark pools are completely invisible to the general public, while retail investors can still access over-the-counter (OTC) exchanges.
What percentage of trading is dark pool?
According to some research, dark pools accounted for 13.75% of the equity volume in the U.S. in December 2022.
What is the difference between ATS and dark pool?
A dark pool is a type of alternative trading system (ATS). While some ATS can be publicly available and transparent, all dark pools are exclusive and private.
How to track institutional investors?
To track institutional investors, we recommend Finbold Signals, which delivers real-time information about relevant institutional investing developments.
How to monitor dark pools?
Although dark pools have limited transparency, you can still find some data on dark pool activity via specific data platforms and services and indirect effects on public exchanges.
What is the dark pool controversy?
The most recent dark pool controversy revolves around the Barclays LX dark pool, with clients suing due to alleged misleading information about transparency and safety. Barclays was accused of promoting LX as a safe space with protections against predatory trading while also favoring high-frequency traders who exploited orders from others.
