There are two reasons one may choose to conduct dark pool trading. First, it could make your job sound far more thrilling than it actually is. “Stock analyst” might not light up the conversation at a party. “Dark pool traders,” on the other hand, probably ride motorcycles to work at an undisclosed location. No one will know what you do. And, for security purposes, you can’t tell them.
The second, more practical reason is to conduct trades without influencing the market. Dark pool investing is a straightforward solution to a relatively common problem. However, it’s not a problem many retail investors will likely have. Here’s a breakdown of dark pool investing.
What Is Dark Pool Investing?
Dark pools, otherwise known as Alternative Trading Systems (ATS), are legal private securities marketplaces. In a dark pool trading system investors place buy and sell orders without disclosing either the price of their trade or the number of shares.
Dark pool trades are made “over the counter.” This means that the stocks are traded directly between the buyer and seller, oftentimes with the help of a broker. Instead of relying on centralized pricing, such as with a public exchanges like the NYSE, over-the-counter traders reach their price agreements privately.
There are three common types of dark pools: broker-dealer owned, agency broker or exchange-owned and electronic market makers. The first type is set up by broker dealers for their clients and may include proprietary trading. These prices come from their own order flow. The second acts like an agent rather than a principal and there is no price discover as the prices come from exchanges. The last type is offered by independent operators and there is no price discovery.
Dark pool exchanges keep their confidentiality because of this over-the-counter model, in which neither party has to disclose any identifying or price information unless specific conditions compel them to. For example, a public institution might have to publish this information due to disclosure laws that have nothing to do with the dark pool.
Why do Dark Pools Exist?
Chiefly, dark pools exist for large scale investors that don’t want to influence the market through their trades.
The influence they could potentially have on the market is often known as the Icahn Lift, named after legendary investor Carl Icahn. It’s been said that Icahn can influence the price of a stock just by purchasing it. The “lift” comes when other investors see Icahn’s interest and jump in, causing the stock price to rise. He’s often seen as a one-man bull market.
This happens to large scale investors, too. When an institutional investor wants to shift assets, it risks creating a price swing due to other investors who see the interest or disinterest and react accordingly. This isn’t always a good thing.
Prices can Spiral due to Large Purchases
Consider a trader known for takeover bids. If they begin buying shares of stock in a company, other traders might assume that they plan an acquisition. That could set off a rush to buy the stock, sending its price through the roof and making the takeover far more expensive.
Or consider a company in the middle of a good-faith share buyback. The board is not looking to enrich itself, just restructure the company. Yet as the company begins to buy all of its own shares off the market, the price will spiral, pushing expenses (and potentially debt) higher.
A public exchange would publish all of this information through its central marketplace. Investors would immediately know about the takeover or share buyback in progress and would trade accordingly. On a dark pool, these parties can keep things quiet a little longer and hopefully not get hit with spiraling prices.
Prices can Fall due to Large Sales
Let’s assume a mutual fund wants to sell 1.5 million shares of a company. It’s very unlikely that the fund will sell all of these shares at once. Instead it will have to sell in parcels, finding a buyer for 10,000 shares here and 1,500 shares there.
Once the market gets word that the mutual fund is liquidating its shares, the price will quickly drop. The sudden rush of available stock will push its price down. And if this is a particularly well-respected fund, the public loss of confidence might depress the stock price further. This means that every new buyer will pay less and less for each parcel of the mutual fund’s stock.
Word of this would get out immediately on a public exchange. Through a dark pool, the mutual fund can try to sell off its shares without alerting the market and causing a run on the company’s stock.
Dark Pools and You
There’s no practical chance that an average retail trader will shift the market. Unless you manage a substantial portfolio, your influence on the market most likely isn’t going to drastically influence other investors. Technically, you buying a company’s stock will affect share prices, but practically, it won’t be to any measurable degree.
As a result, a retail investor typically has little use for dark pool investments. This is true despite the surge in popularity that dark pool trading has enjoyed in recent years.
Dark pool investing has become one of the overwhelmingly most popular ways to trade stocks. In April 2019, the share of U.S. stock trades executed on dark pools and other off-market vehicles was almost 39%, according to a Wall Street Journal report.
Traders who are interested in exploring anonymous, dark pool trading can do so relatively easily. The SEC has registered more than 50 different ATS services, which each offer products depending on your needs and investor profile.
However, it is generally inadvisable to do so. As a retail investor not only will you have relatively little use for the anonymity that a dark pool exchange provides, you may also expose yourself to several risks not present on a public exchange.
All over-the-counter trades involve a certain amount of risk that you will pay too much or too little. Although, in the case of dark pool trading, you can mitigate that by aligning your trades with the publicly available data. However, traders on a dark pool are typically acting in advance of the market. The stocks that you buy or sell today could swing wildly in price quite soon.
The average size of a dark pool transaction has dropped to little more than 180 to 200 shares per transaction. This is a far cry from the original intent of ATS. Nevertheless, dark pool exchanges are built for institutional investors looking to act in advance of market knowledge. These traders typically have far more experience than a retail investor and have information about the product they are buying or selling that you do not. Acting in this market means taking a significant risk that this information will prove valuable.
The Bottom Line
Dark pool investing isn’t usually something the average retail investor will take part in, but it may be useful for institutional investors and companies. When large scale investors plan to buy or sell a substantial amount of stock, it could influence other investors to do the same, affecting the entire market significantly. Dark pool trading helps prevent that from happening. However, there is still significant risk that comes with this type of investing.
Tips for Dark Pool Investors
- If you’re interested in dark pool investing, consider working with a financial advisor to ensure it’s the right move for you. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- Before considering dark pool investing, be sure to consider all of the investment types out there. From stocks and bonds to mutual funds and CDs, there’s sure to be one that’s the right fit for you and your experience level.
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