An Introduction To Dark Pools
What is a dark pool?
Dark pools were created specifically to allow big institutional investors to swap large blocks of shares privately, and retail investors who leverage this data can gain an unfair advantage in the stock market.
In juxtaposition to the USA’s “free market” narrative, more shares now change hands in dark pools than on the entire New York Stock Exchange.
Many experienced authors and Universities suggest that dark pools unfairly prey on smaller individual investors. And this is our mission to change it. We, at Portfolio Insider, are one of the leading authorities on dark exchange activity through our proprietary machine learning algorithms. 💡
Dark pools are developed to permit institutional investors to execute large order blocks without exposing their new positions to the general public. The reason is simple. Disguising large orders from Wall Street “whales” help to avoid the disproportionate impact of big sales or purchases on securities prices and market sentiments
Originally established in 1980 to facilitate large transactions for institutions, the off-market trading system is now open for everyone. In fact, it topped public trading volume several times this year. This is unusual. Dark pool trading volume averaged around 40% of the overall market volume in recent years, but the robust growth in volume from retail investors shot up the popularity of dark pool.
What caused the surge in volume from retail investors? The SEC ruled in 2007 to allow investors to bypass public exchanges, so they can gain price improvements. As a result, retail investors flocked to dark pools, driving up the trading volume. Investors also love the dark pool for these benefits: lower fee structure, anonymity, increased market efficiency, and higher liquidity.
A brief history of dark pool:
- In 1979, The U.S. Securities and Exchange Commission allowed securities to trade in off-exchanges.
- In 1980, dark pools emerged and started allowing investors to trade large block orders.
- In 1986, the famous dark pool trading venue, known as “After Hours Cross,” was started by Instinet — an institutional, agency-model broker under its parent company, Nomura Group.
- In 1987, ITG, a United States-based multinational agency brokerage and financial markets technology firm, created the first intraday dark pool “POSIT”.
- In 2007, the SEC passed NMS (National Market System) legislation, which is considered as an inflection point for the trading volume at dark pools.
Nearly half of all stocks are traded on dark exchanges:
National Market System, a law designed to increase competition and cut transaction costs, stimulated an increase in the number of dark pools. While institutional investors account for the major portion of dark pools trading volumes, zero commission apps like Robinhood have started offering dark pool services to retail investors. This dark pool service was previously only available to big investors.
In January 2021, a record 47.2% of U.S. equity trading volume was executed through dark pools — according to data from Rosenblatt Securities. This was the time when retail investors started targeting meme stocks like GameStop, and institutional investors joined the party by making their big bets through dark pools. Off-exchange trading volume surpassed regulated exchanges trading volume three times in January and one time in April. Before 2020, dark pools trading volume averaged around 40% of the overall trading.
Electronic trading firms such as Citadel Securities’ strategy of executing small investors’ orders privately rather than following a public markets route helped to lift the dark pool volume.
Small and micro-cap stocks that are trading less than a dollar account for the major portion of dark pools trading volume, reducing the percentage of overall exchanges volume to 40% when measured in dollars. Furthermore, the data suggests 92% of orders from retail traders are under $20,000, with an average of around $8,000.
High-Frequency Trading Is Pushing More Institutional Investors to Dark Pool Trading:
The explosion of quantitative and higher frequency trading also fueled institutional investors’ interest in the dark pool. Here’s why. With the rise of supercomputers, big investors can execute algorithmic-based programs in just milliseconds. So, the HFT technology permits institutional investors to make multimillion-share blocks orders well ahead of other investors, profiting from the upside or downside of the share price movement. However, to avoid public exposure, institutional investors are using dark pools for their HFT strategies.
Advantages and Disadvantages of Dark Pools
Below are a few advantages and disadvantages of dark pools:
👉 1. Secrecy in trading
Dark pools are created to avoid spotlighting large buy and sell orders because public markets often react strongly to big orders. However, the impact on the price movement declines when these transactions occur secretly.
👉 2. Increased market liquidity
The popularity of dark pools has increased liquidity in securities for institutional investors and retail investors.
👉 3. Lower Transaction Costs
Dark pools may also lower transaction costs because these private exchanges don’t have to pay fees to public exchanges.
Disadvantages:
❌ 1. Lack of transparency
While dark pools address institutional investors’ needs, the lack of transparency and regulatory control could lead to market manipulation activities.
❌ 2. Unfair advantages
Institutional investors have an unfair advantage of using HFT strategies and making big orders to capitalize on short-term price movements.
At Portfolio Insider, we believe that sharing market data in nanoseconds is vital to our democratic role in making the stock market fair and efficient for everyone.
Our team includes free-market economists, computer scientists with backgrounds from MIT and Harvard, as well as analysts from all walks of life.
And we contribute to human progress by democratizing access to the world's most valuable dark exchange information.
*If you are a high frequency (HFT) trader or work within a dark exchange, please contact us at support (at) portfolioinsider.com 🌆
