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What are Dark Pools?
With mutual and pension funds managing billions of dollars these days, it is important for them not to give too much information away. They don’t want the market to act against them when they are about to conduct a large transaction. Thus the evolution of something called “dark pools”
A dark pool may sound very mysterious, but it is actually a practice that has been around since the beginning of stock trading. For example, large sell-side firms like Morgan Stanley or Goldman Sachs receive continuous streams of orders from their institutional customers. If they have one selling and one buying large blocks of the same stock, they will cross the transaction. Nowadays, dark pools are electronic networks that match orders anonymously in off-exchange trading and the transactions are only made public after they are completed. Dark pools are taking market share away from the NYSE and NASDAQ and have grown popular because they allow institutional traders, such as hedge funds, pension funds and mutual funds, to sell or buy large blocks of stock without impacting the prices. By trading dark, they don’t tip their hand to the traders who may move the market and they also skip high exchange fees.
Execution speed is crucial in dark pools which now account for 1 out of every 3 stocks traded. The stock exchanges are calling for increased regulation of dark pools. They are not only worried about the drain in liquidity, but also by the creation of multi-tiered markets. This means that the public prices on the stock exchanges are less accurate. Options exchanges are also worried about this proliferation because an option is valued off the price of the underlying stock. The concerns are heightened by the fact that in some cases, as reported by the Wall Street Journal on January 4 2011, dark trading in some securities was more than half of the volume. The newspaper cites that two-thirds of trading in tech stock Level 3 Communications Inc. took place off-exchanges.
Concerned investors have raised many questions about dark pools such as about the transparency of reported data. These are time-stamped not at the time of execution but at the time the event was reported to the consolidated tape.
Many Wall Street firms and banks own dark pool units. Goldman Sachs has Sigma X, Credit Suisse has Crossfinder and market maker Getco owns Execution Services. There are also private ventures, among LiquidNet and ITG, the two pioneers in dark pools.
Canada has only two dark pools now – LiquidNet Canada and MATCH Now owned by ITG but expect many more including IntraSpread to be launched. It is owned by the Alpha Group, which was founded by the largest Canadian banks and the Canadian Pension Plan Investment Board.