What it means
When a pension fund wants to sell two million shares, showing that order on a public exchange could push the price down before it finishes selling. Dark pools exist to reduce that effect, called market impact.
Orders sit unseen until a matching buyer or seller arrives, and then the trade is executed, often at a price derived from the public market. Dark pools are run by brokers, banks, exchanges or independent operators and are regulated as trading venues.
Participants may include asset managers, hedge funds and brokers acting for clients. The key feature is lack of pre-trade transparency, meaning that other participants cannot see the order book.
For the investors who use them, the benefits are lower market impact and often lower trading costs. The drawbacks are the risk that no match is found, a lower fill rate, and concerns about fairness.
Critics point out that when a large share of volume trades privately, the public price may be based on a smaller part of the market, and that some participants can use sophisticated tools to detect large orders. Regulators in many countries monitor dark pools and set rules for reporting and, in some cases, limit the share of trading allowed in them.
Details differ from country to country and change over time, so the current rules of the relevant market should be checked. Post-trade reporting means the volumes eventually appear in market data.
The nuance is that dark does not mean illegal or secret in the sense of hidden from authorities. Regulators can see the trades, and the main difference is in what other traders can see before the trade.
Understanding that distinction avoids confusion when dark pools are described in the media as shadowy.
In practice
Real-world examples.
Example
A mutual fund needs to cut a large holding in a mid-sized company, where daily trading volume is thin. The trader routes part of the order to a dark pool and the rest to the public market in small pieces over several days. The average price achieved is better than if the whole order had been shown on the exchange.
Example
An investment bank offers a dark pool to its clients and matches their orders internally before sending any residual to public venues. The bank's compliance team monitors the pool for conflicts of interest, such as the bank trading against its own clients. It reports the volumes to its regulator.
Example
A retail investor reads that nearly half of the trading in a particular stock took place away from public exchanges. She learns that the figure includes dark pools and other off-exchange venues. She concludes that the visible order book on her trading app shows only part of the market.
Formula
Calculation
Market impact cost = shares traded x share price x impact rate; saving = impact cost in public market - impact cost in dark pool
Suppose a fund sells 500,000 shares priced at $40, a total of $20,000,000. In the public market, the order is expected to move the price against the fund by 0.40%, costing 20,000,000 x 0.004 = $80,000. In a dark pool, the expected impact is 0.10%, costing 20,000,000 x 0.001 = $20,000. The saving is 80,000 - 20,000 = $60,000, or 0.30% of the trade value, before allowing for the risk of an incomplete fill.Case study
Seen in the real world.
Ashgrove Pension Trust is an illustrative, fictional fund that needed to sell $60,000,000 of shares in a listed retailer after a change in its investment policy. Its trading desk was worried that a visible sell order would alarm the market.
The head trader split the order. About half went through a dark pool where it could be matched against natural buyers, and the remainder was worked gradually through the public market using a volume-weighted strategy.
When the finance team compared the cost with a benchmark, the total cost of trading was 0.18% of the value traded, compared with the 0.45% they had estimated for a single public order. In this illustrative story, the trust saved roughly $162,000 and recorded the lessons in its execution policy.
Watch out
Common mistakes.
- Assuming dark pools are illegal or unregulated, when they are operated by regulated firms and report trades after they take place.
- Assuming a dark pool always gives a better price, when the order may not be filled and the investor may have to trade later at a worse price.
- Reading the share of off-exchange volume as only dark pool activity, when it also includes other kinds of private trading.
Questions
People also ask.
Why do institutions use dark pools?
To buy or sell large quantities without moving the market price against them before the order is complete.
Can retail investors trade in dark pools?
Not usually directly, but their brokers may route some orders to such venues, and the broker must disclose its order routing practices.
Does dark pool trading affect the share price?
It can, because trades away from public venues reduce the amount of visible demand and supply, although the post-trade reports still feed into market data.
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