Dark pools are OTC (over the counter) markets for transacting stock trades, whose function is essentially similar to that of normal stock exchanges, with the important difference that market information is not made public. The advantage of such a market is that extremely large, instutional trades can be executed without severely shifting the market. The disadvantage, of course, is that the general market is deprived of dark pool trade information. It is important to note that dark pools are regulated entities registered with the SEC and FINRA.
Q. We know that the NYSE recently got permission from the SEC to run one of these… but exactly what are they?
A. The new NYSE platform aside for one moment, they are essentially private exchanges, places where stocks trade without the same kind of reporting that goes on with the public exchanges. That’s what’s “dark” about them. They grew up as places for very large institutional block trades to get done at the best price — previously, for example, a large block order to buy a stock would be visible to everyone and might cause the price to rise by itself, so the buyer wouldn’t get the best price. But now, in many of the biggest stocks, more than half the volume is occurring in dark pools. And they account for maybe 14% of total trading volume.
Q. And now the NYSE is now creating its own?
A. Yes. I guess you could say they’re fighting fire with fire. They say its good for retail investors because they’ll be able to get sub-penny pricing, which has been a feature of dark pools for a while. And the NYSE version is meant specifically to work only for retail investors; institutional traders are not allowed.
Q. But isn’t all this activity hurting price discovery? If all the trading gets moved to platforms where people don’t see the bid and ask, how does anyone know what the market for a particular stock really is?
A. That’s the problem all right, and so is the resulting diminishment of liquidity. You can only spread the given liquidity through so many markets before it gets thin. And, of course, less liquid, less transparent markets can be a fertile ground for algo traders who are members of various dark pools… it’s all a little bit of a crazy, computer-driven arms race.
Q. And I guess if the NYSE is doing this, the NASDAQ can’t be far behind.
A. Right, they’re submitting a plan for SEC approval, too. Overall, it seems that there’s quite a trend for more, different trading platforms with different rules open to different sets of investors. Even if liquidity and price transparency don’t become real market problems, all this does make you worry about why and how order flow gets directed where. Lots of competing motives out there.