Explainer: what are dark pools?

Where traders lurk. byronv2

Explainer: what are dark pools?

Where traders lurk. byronv2

A draft agreement for an overhaul of EU securities trading regulation has now, eventually, been reached. Among other things, some new rules have been designed to regulate the use of “dark pools”.

So what are these nefarious sounding trading venues, and where have they come from? As dark pool usage has grown rapidly in recent times, it is worth trying to understand whether this growth might have had a beneficial or a detrimental effect on the operation of securities markets (mainly for stocks and shares).

Roughly speaking a dark pool is a trading system that does not publish information on outstanding orders to buy or sell. Thus one can place an order to sell, say, but not advertise the fact that you wish to sell to the rest of the world. Then, periodically, buy and sell orders are matched with one another at a price that is usually derived from a “lit” (that is, not dark) market. After the trade is completed, the details (price and size) are published. Note, though, that there is no guarantee that if you submit an order to a dark pool, a trade will result (there will only be an execution if an order on the other side of the market arrives).

Thus, for example, a trader who wants to buy stock in Marks and Spencer might submit a buy order to a dark pool. Subsequently, if another trader has submitted a sell order for M&S to the pool, then the buyer’s order and seller’s order may be matched. If no such seller arrives then the buyer’s order goes unfilled but, importantly, no-one aside from the buyer knows that the order ever existed.

Pros and cons

Dark pools have some clear advantages, particularly for institutional traders. The fact that unexecuted orders are not visible to all market participants means that institutions can trade more stealthily, and thus hopefully more cheaply. For a big trader, keeping one’s intentions quiet is of paramount importance, especially in the modern world where high-frequency traders are quick to exploit predictable order flows from less nimble operators. Less visible trading translates into smaller impact on prices. Dark pool trades usually execute at better prices than those on lit markets and direct costs of trading on dark venues are often below those on lit venues.

There are, of course, also some drawbacks associated with dark trading. If big traders were to migrate to dark pools in sufficient numbers, then liquidity on lit markets such as the London Stock Exchange could suffer. Less trading on lit markets would likely lead to an increase in trading costs on those markets and also a reduction in market efficiency (as trading is a major part of the process through which information gets into prices).

There is also the issue that dark pools attract less well informed traders than lit markets. If dark pools siphon off uninformed trading, the lit markets could end up becoming dominated by informed traders and thus more “toxic”. In the end, regular lit markets would be both more expensive to trade and their prices less informative, and these are the prices which are then used to set terms of trade in dark markets.

What’s the evidence?

Recently, empirical evidence has been produced that allows one to evaluate some of these claims. Work on US markets suggests that, at low levels, dark pool activity might actually improve the quality of lit markets, making them cheaper to trade, easier to trade big quantities on and less volatile. This effect is likely a benefit of increased competition between trading venues.

However, there have been suggestions from US and Australian data that when dark pool trading becomes relatively large (say more than 10% of overall volume), lit market quality suffers. This is probably driven by successful dark pools attracting much of the uninformed trading activity, leaving lit markets populated by informed traders. Markets populated by informed traders are expensive to trade in.

This evidence suggests that EU regulators are correct to worry about dark trading to some extent. When dark trading accounts for too much of the activity in a particular stock, measures to rein it in are sensible. Some guide as to what “too much of the activity” is can be drawn from the research mentioned above. If use of dark markets remains steady, though, then little needs to be done other than to make sure that dark pools are really offering traders better prices than lit markets.

As it turns out, new EU trading regulations may affect dark pools through an indirect channel as well. The new rules also include provisions to limit high frequency trading, and if these limits were adopted this would probably reduce institutions’ incentives to seek to trade away from lit markets. As their predators will have been constrained, there may be a natural movement of trading activity back into the light and out of the dark.