The Murky Waters of Dark Pools

Recently, an article in the WSJ about Goldman Sachs recent strategies had a long section about “dark pools.”  Although I had heard about them briefly, I didn’t really understand what exactly they were, and so I decided to read a bit more about them and learn what they were and how they operated.  The resulting blog post is what I found.

A dark pool is essentially an alternative market where firms can trade with orders that are unavailable to the public market.  On these markets, firms are able to trade more anonymously; when they set and order, others who are in the dark pool can see that someone has placed an order, but cannot tell the position of the order.  This is often used when institutional investors want to move large amounts of an assets without changing the price in the market.  For example, if a large firm like Goldman Sachs wanted to buy a large amount of a certain type of asset, the price of that asset would shoot upward as they repositioned themselves.  However, if they made the purchase in a dark pool, they could buy at a lower price, and the transaction would hit the public books only after the purchase was complete.  Although relatively unknown to laypeople, a substantial portion of trades (12% in 2012, and rising).

Dark pools also play an important role in the current high-frequency trading controversy.  HFTs buy access into Wall Street bank’s dark pools, and then use their access to this private to benefit themselves.  HFTs will send out many small orders to these dark pools, fishing for a counterparty.  If an order gets executed, then the trader can guess that the large firm is taking a larger position that they cannot see.  When a HFT makes this inference, they then take the same position on a public market.  When the large firm’s order is filled in the dark pool, the transaction moves the asset’s price in the market in the way that benefits the HFT.  They pay a fee to have access to these banks dark pools, so both sides end up winning.  In Flash Boys, Michael Lewis argues against this strategy, commonly called “front-running”.

In 2012, Pipeline Trading Systems was accused of front-running people who made orders with their affiliate, and eventually was shut down after pressure from the SEC.

Dark pools seem to be queer bit of financial engineering.  They reduce the amount of information a typical market participant knows about the demand for an asset at any given time, because they don’t have access to who is trying to buy what in dark pools.  Dark pools seem to be a way for large firms to circumvent the market forces of supply and demand in order to buy lower and sell higher than would be possible on the open market.  I understand that someone making a large investment position change doesn’t necessarily want to broadcast it to the rest of the world, but I’m not sure if dark pools are the solution.

 

One thought on “The Murky Waters of Dark Pools

  1. zsalem

    Price determination is done in the stock market, a more or less public form. When you rely on the information in the public to deduce prices privately, that doesn’t help price determination. The value of assets will have a harder time being determined if we move from public to private trading pools.

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