The purpose of this paper is to put some “light” over the phenomenon of Dark Pools. Firstly I will give a brief description of what they are, their biggest difference with the normal exchange market, the increasing volume and market share of these Dark-Venues. Secondly I will go through the advantages and disadvantages of trading in a Dark Pool, and finally I will spend some time on how regulators behave and how they should behave about this phenomenon.
A Dark Pool is defined as a trading venue that is alternative to traditional exchanges, so an Alternative Trading System.
The peculiarity of these Dark Exchanges is that the bid-ask quotes are not posted and traders are automatically crossed, related to the volume and price they submitted into this “pool”, by a system that maintains complete anonymity of the actors involved until the trade is executed, so everyone will know about the order eventually, but there is a time delay.
These electronic venues were originally created to protect institutional investors and pension funds to hide big buy and sell orders. This is because traders on “Lit” exchanges, if able to spot a big order or to see a pattern in the selling or buying of stocks, can take advantage by driving the offered share price up or down depending on how this order will affect the demand and offer of the stock. But, as said before, this can’t happen in a Dark Pool as the order volume is not displayed, hence institutional investors can act without fearing the response of other traders.
It’s important to understand that these Dark Pools have been around for a long time, they were called “upstairs trading”, but recently they have become more and more popular, the use of these alternative trading systems has significantly increased since the MiFID (The Markets in Financial Instruments Directive) implementation in 2007, because, among all directives, it abolished concentration rules, resulting in the fragmentation of dark and lit markets. Nowadays we count more than 60 Dark Pools against only 13 lit exchanges. A research done by Bond University shows the proportion of trading volume between dark and lit exchanges, it’s interesting to notice how the volume abruptly increased in 2007 (Figure 1.1).
Moreover this research shows that volume in Dark Pools was constructed by a small number of big transactions, but this is changing to a preference for a higher number of small transactions.
Figure 1.2 easily shows the increasing trend of using Dark Pools in Europe and in the US.
3. Advantages and Disadvantages
As in all exchanges there are different actors involved in Dark Pools, and each of these have advantages and disadvantages in trading in this alternative system. These actors can be classified as: buy-side, sell-side, government, regulators and the providers of the trading facility.
An advantage given by trading in a Dark Pool is the anonymity in selling or buying large orders of stocks without fearing the impact on the market, and you can trade fairly illiquid stocks in a very discreet manner. Secondly it’s easier to trade these large blocks in the dark rather than in a lit market and you can better control your order. Lastly transaction costs are minimized, as the bid-ask spread is tightened. It’s also important to say that usually traders prefer to operate through Dark Pools, saying that this is the best for their clients. These last advantages can be attributed to both the buy-side and the sell-side. As said by Dr. Keith Ross: “Dark Markets are so efficient that the cost of execution in market impact are lower than at the display markets where fees are highest and market impact is the most significant… Competition for liquidity has created alternative venues like Dark Pools that offer a better experience for traders and investors”.
On the other hand there are a lot of disadvantages relating Dark Pools, the biggest…