Dark Pools – Looking Past the Assumptions
June 15, 2009
Regulators in the U.S. and abroad are taking a closer look at dark pools. Despite the sinister connotation of the term, dark pools have brought about a number of positive changes for market participants, most notably reduced trading costs and more efficient execution of block trades. When considering the issue of dark pools, it is important to go beyond the assumptions and understand what dark pools are, why they exist and how they operate.
Assumption: Dark pools are off-exchange trading venues.
Reality: Dark pools operate on and off-exchange; every exchange and major trading system is at least “semi-dark.”
Dark liquidity refers to orders that are not displayed to the market. All of the major exchanges, including the NYSE and NASDAQ, provide order types that permit the non-display of all or a portion of an order. Conversely, many off-exchange venues, like ECNs, publicly display their orders. A dark pool, in effect, is functionality, whether on or off-exchange, that allows for non-display of an order. As of today, all the major trading systems, both on and off-exchange, include some component of dark liquidity and can be described as “semi-dark” pools.
Assumption: Dark pools present a new challenge to market transparency.
Reality: Non-displayed liquidity has existed since the dawn of trading.
Non-displayed liquidity is not a new concept. In any financial market, an investor with a large buy or sell order will seek to protect the confidentiality of the order because leakage of the investor’s order invariably will result in adverse price movement against the investor.
Traditionally, institutional investors worked their large block orders through block trading desks operated by broker-dealers. In many cases, the institution only exposed a small portion of its order to the block trading desk, and the block trading desk, in turn, only exposed a small portion of the order to the market. This resulted in liquidity sitting dark either at the institution or at the broker-dealer, with limited opportunity to interact with other liquidity in the market. In the best case, the block trading desk, operating as a manual dark pool, could cross the institution’s block order with another institution’s block order.
With the advent of electronic dark pools, the process is now more efficient in two respects. First, institutions can protect their order information without disclosing their orders to conflicted broker-dealers who trade as both principal and agent. Second, with the continuing development of smart order routing technology and the linkage of dark pools with each other and with other trading venues, there is much greater opportunity for institutional liquidity to interact with other liquidity in the market, to the advantage of all market participants.
Assumption: Dark pools cause market fragmentation.
Reality: Linking of dark pools is reducing market fragmentation.
Innovations solve existing problems in the market and create new challenges. Dark pools are no different.
Dark pools have made it easier and less costly to trade blocks. Dark pools also have led to fragmentation. The market is addressing fragmentation through improved smart order routing and the linkage of broker and exchange-operated dark pools with each other and with other trading venues. The current market is an improvement over traditional markets where fragmented liquidity could not interact.
