Independent Dark Pools
Independent dark pools are privately owned and operated alternative trading systems (ATS). They are not owned by a bank or a broker-dealer. These platforms offer a neutral trading environment where participants can execute large block trades without revealing their intentions to the public market. The primary advantage of independent dark pools is the reduction of market impact. A large order in the public market can cause the price to move against the trader. In a dark pool, the trade is executed anonymously, so the price remains stable.
One of the largest independent dark pools is the one operated by the Independent Research and Trading Group (ITG). ITG's POSIT dark pool is one of the oldest and most established dark pools in the world. It allows institutional investors to trade large blocks of shares with minimal market impact. For example, a pension fund that wants to sell 500,000 shares of Apple (AAPL) can place the order in POSIT. The order will be matched with other buy orders in the dark pool. The trade will be executed at the midpoint of the national best bid and offer (NBBO). This means the pension fund will get a better price than if it had sold the shares in the public market.
However, independent dark pools are not without their drawbacks. One of the main concerns is the lack of transparency. Since the trades are executed anonymously, it is difficult to know who is on the other side of the trade. This can lead to concerns about front-running and other predatory trading practices. Another concern is the potential for information leakage. Even though the trades are executed anonymously, there is still a risk that information about the trade could leak out to the public market. This could cause the price to move against the trader.
Broker-Dealer-Owned Dark Pools
Broker-dealer-owned dark pools are owned and operated by large banks and broker-dealers. These dark pools are often used by the broker-dealer's own clients to execute trades. One of the main advantages of broker-dealer-owned dark pools is the access to a large pool of liquidity. Since the broker-dealer has a large number of clients, there is a high probability that there will be a matching order in the dark pool. This can lead to faster execution and better prices.
One of the largest broker-dealer-owned dark pools is Goldman Sachs' Sigma X. Sigma X is a non-displayed liquidity pool that allows clients to trade with other Goldman Sachs clients and with the firm's own proprietary trading desk. For example, a hedge fund that wants to buy 100,000 shares of Tesla (TSLA) can place the order in Sigma X. The order will be matched with other sell orders in the dark pool. The trade will be executed at a price that is better than the NBBO.
However, broker-dealer-owned dark pools also have their disadvantages. One of the main concerns is the potential for conflicts of interest. Since the broker-dealer owns the dark pool, there is a risk that the broker-dealer could use the dark pool to its own advantage. For example, the broker-dealer could front-run its own clients' orders. Another concern is the lack of transparency. As with independent dark pools, it is difficult to know who is on the other side of the trade. This can lead to concerns about predatory trading practices.
Worked Trade Example
A trader wants to buy 10,000 shares of SPY. The NBBO is $400.00 x $400.02. The trader places a buy order in a dark pool with a limit price of $400.01. The order is matched with a sell order in the dark pool at $400.01. The trade is executed and the trader buys 10,000 shares of SPY at $400.01. The trader saved $100 on the trade compared to buying the shares in the public market at the offer price of $400.02.
- Entry: $400.01
- Stop: $399.50
- Target: $401.00
- R:R: 1.94
This concept works when there is sufficient liquidity in the dark pool to execute the trade. It fails when there is not enough liquidity, forcing the trader to route the order to the public market, where it can be subject to market impact.
Key Takeaways
- Dark pools are private exchanges for trading securities that are not accessible by the investing public.
- The main advantage of dark pools is the ability to execute large trades with minimal market impact.
- There are three main types of dark pools: independent, broker-dealer-owned, and exchange-owned.
- Dark pools have been criticized for their lack of transparency and the potential for conflicts of interest.
