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Introduction to dark pools in the stock and FX markets

“The hidden passages and trapdoors that riddled the exchanges enabled a handful of players to exploit everyone else.” – Michael Lewis, Flash Boys

What is a dark pool?

The term “dark pool” refers to private exchanges that, unlike stock exchanges, are not accessible to the overall investing public. They were created by big Wall Street firms to allow for the anonymous execution of large trading orders (block trades) for their clients.

The main purpose of dark pools is to facilitate and execute block trades for large investors at favourable prices, which would otherwise have a significant market impact if executed on regular exchanges. In this way, although the dark pools’ lack of transparency is beneficial to their participants, it has recently also spurred some controversy over potential conflicts of interest and vulnerability to high-frequency traders, who use dark pools to front-run large orders and profit at the expense of real investors.

However, dark pools can be of real benefit to large investors who want to execute their orders. Let’s consider the options that such an investor had before the advent of off-exchanges such as dark pools. If an investor wanted to sell shares that represent 10% of a particular company, doing so on a regular exchange would have a significant market impact, leaving the investor with an unfavourable price for their shares. Even splitting the order up into smaller pieces would still have a sizeable market impact. Dark pools would provide the best execution conditions for such an investor, as trading intentions are not disclosed before the order execution, and therefore no order books are available to the public. Trades are only reported with a delay on the consolidated tape.

Although dark pools came into existence in the 1980s, they recently hit the headlines again with Michael Lewis’ best-seller book “Flash Boys”. The author presented dark pools in a very unfavourable light, comparing them to casino owners who try to attract players. “You invite a few to start Texas Hold ‘Em by telling them that the deck doesn’t have any jacks or queens and that they won’t tell that info to other people joining the game.”

Dark pools on the FX market

Although dark pools are usually associated with the stock market, they are also used by participants of other markets such as the foreign exchange market. As the Forex market is naturally used for hedging and funding the needs of companies, many participants may move toward dark pools to obtain marginally better conditions for their trades. Big players in the FX market; mainly big banks, are also keen to avoid the market impact, which may go against them when placing large trades.

Dark pools are a solution to this, and their popularity is rising in the FX market as they offer protection from negative market impact, secrecy from competing banks, and lower volatility of the price itself. Large FX participants, such as Credit Suisse, Deutsche Bank, and UBS, already operate their own FX dark pools, and the use of dark pools in the FX market on both the buy and sell side is expected to rise in the future.

Trading volume of dark pools

Trading off-exchange in the United States has skyrocketed in recent years, accounting for 40% of the volume of all US stock trades in 2014. This marks a significant increase from around 16% in 2008, and represents trillions of dollars given that 21.4 trillion USD worth of US stocks that were traded in 2012. According to John Ramsay, former head of the US SEC’s Trading and Market division, “… we have academic data now that suggests that, yes, in fact there is a point beyond which the level of dark trading for particular securities can really erode market quality.”

Types of dark pools

Dark pools can be grouped into three main types: broker-dealer-owned, agency broker or exchange-owned, and electronic market makers.

Broker-dealer-owned dark pools are set up by large broker-dealers for their clients, and derive their prices from order flow. These types of dark pools can also include the broker-dealers’ own proprietary traders.

Agency broker or exchange-owned dark pools act primarily as agents and derive their prices from exchanges, while electronic market makers are dark pools that act as principals for their own account and are run by independent operators.

Advantages and drawbacks of dark pools

The main advantages of dark pools include a reduced market impact for large block trades, so that institutional investors are able to get a better price than they would if they executed their orders on regular exchanges, and lower transaction costs, since no exchange fees are charged on dark pool trades.

On the other hand, dark pools have many drawbacks. The main drawback is that their lack of transparency can lead to the mispricing of securities on regular exchanges. Unaware investors may pay too much for a security, which can collapse in value once a large dark pool order on that stock is disclosed to the public.

The presence of a conflict of interest between dark pool participants and the broker-dealers’ own proprietary traders who may trade against the client is also a rising controversy; a point that Lewis stressed in his book “Flash Boys”. Broker-dealers can also provide special access to the dark pool to high-frequency traders, who may profit at the expense of dark pool participants.

Dark pools are also draining liquidity from public exchanges, especially with their recent rise in trading volume. The main concern associated with this is that open market price discovery is becoming increasingly difficult, and that lower liquidity on exchanges leads to higher transaction costs; with Bid/Ask spreads also increasing.


Dark pools offer a number of pricing advantages to large institutional investors such as banks and mutual funds, and their market share is expected to rise in the future. However, the lack of transparency, potential conflicts of interest, and predatory trading practices have put them under increased scrutiny by regulatory authorities. The “trade-at” rule proposed by the SEC, if implemented, would require brokerages to send their clients’ orders to exchanges unless they can obtain significantly better prices on dark pools.


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