to the Public!
I’ve spoken about “Dark Pools” knowing most investors and financial advisors are unaware of what they are, and/ or, don’t care. But you should!
Dark pools of liquidity are private stock exchanges designed for trading large blocks of securities away from the public eye. These trading venues are called “dark” because of their complete lack of transparency, which benefits the big players but may leave the retail investor at a disadvantage.
Large investors prefer dark pools over public stock exchanges like the NYSE or Nasdaq because they can discreetly buy or sell huge numbers of shares—in the hundreds of thousands or even millions—without worrying about moving the market price of the stock simply by expressing intention. But dark pools have grown so much over the years that experts are now worried that the stock market is no longer able to accurately reflect the price of securities.
Disadvantages of Dark Pools
- Off-market prices may be far from the public market: The prices at which trades are executed in dark pools may diverge from prices displayed in the public markets, which puts retail investors at a huge disadvantage. For example, if a number of large institutions decide independently to dump their holdings of a stock, and the sale gets executed within a dark pool at a price well below the public exchange price, retail buyers who are unaware of the selling that has taken place privately are at an unfair disadvantage.
- Possible inefficiency and abuse: The lack of transparency in dark pools could result in poor execution of trades or abuses such as front-running (buying or selling for one’s own account based on advance knowledge of client orders for a security). Conflicts of interest are also a possibility. For example, the pool operator’s proprietary traders could trade against pool clients. The SEC has already cited violations and fined some banks that operate dark pools.
- Predatory tactics by high-frequency traders: In his bestseller Flash Boys: A Wall Street Revolt, Michael Lewis points out that the opacity of dark pools makes client orders vulnerable to predatory trading practices by high-frequency trading firms. One such practice is called pinging. A high-frequency trading firm puts out small orders so as to detect large hidden orders in dark pools. Once such an order is detected, the firm will front-run it, making profits at the expense of the pool participant. Here’s an example: A high-frequency trading firm places bids and offers in small lots (like 100 shares) for a large number of listed stocks; if an order for stock XYZ gets executed (i.e., someone buys it in the dark pool), this alerts the high-frequency trading firm to the presence of a potentially large institutional order for stock XYZ. The high-frequency trading firm would then scoop up all available shares of XYZ in the market, hoping to sell them back to the institution that is a buyer of these shares.
