Dark pools have gotten some really bad press lately, with accusations of shady activities like front running and misusing retail investor data to make the rich richer. In reality, dark pools tend to benefit retail investors by making trading cheaper.
To explain why that is, let’s first talk about what dark pools are and how they work. And to do that, let’s first go over how most stock trades are made: through open exchanges. It starts when an investor selects a stock, a bid/ask price, and an amount to buy/sell. The investor submits that order request to the brokerage, who passes it on to exchanges where all brokerages, banks, and other financial institutions can submit bid/ask offers for that stock. When a bid and ask price and amount of shares match, the exchange can execute the trade. (This is actually more complicated with things like clearinghouses and whatnot, but you get the general idea).
Brokerages do not always have to go through exchanges. Take, for instance, an online retail brokerage like TD Ameritrade, Schwab, or Robinhood. Any of these brokerages will get requests to, say, buy 100 shares of Apple (AAPL) from one investor at price X and one to sell 100 shares of AAPL at price X. Since the brokerage has both requests at the same time, it can execute the trade off-exchange, by simply transferring the shares/money from the buyer and seller, because both are clients of the same brokerage.
This is an example of a dark pool transaction, although the popular view is much more sinister. And in reality, many transactions in dark pools aren’t like this at all—they’re typically between large financial institutions, including oft-maligned hedge funds, but also including insurance companies, investment banks, and other firms.
In a dark pool transaction, the sale is done privately between, say, Hedge Fund A and Insurance Company B. Both A and B are clients of Brokerage Alpha, so Brokerage Alpha can execute the trade between the two without going to an exchange. None of this is illegal, and it’s hard to say how a private transaction between two institutions is immoral, since neither is typically acting with more information than what is publicly available to all.
Why do dark pool transactions exist? In the vast majority of cases, dark pools exist to provide liquidity. Institutions trade very large amounts of stock at once, and when they do so they need access to a lot of shares at once. Dark pools help match large investors with large investors to ensure liquidity, and since many dark pools exist separate and disconnected from one another, large institutions can tap into several dark pools to get the most amount of liquidity possible from various sources without their trades being publicly known and moving the market.
Many retail investors think this is bad—if a large institution trades, the world should know immediately and move accordingly. In reality, this doesn’t make much sense, because such transparency could create higher volatility as people often misunderstand selling activity. For instance, if Hedge Fund A wants to sell $10 million in AAPL, that most likely isn’t because the fund thinks AAPL is going to crash (often, sales are made for redeeming investors, to hedge a position, or to lower risk—selling because a crash is expected in the near term is very rare). But with that information available, misinformed and illinformed retail traders could create massive confusion through rumors, chatter, and so on based on these real-time trades. The current system of quarterly updates provides much less volatility based on misunderstanding whale trader movements.
This isn’t the real benefit of dark pools, however. Many investors in dark pools rely on data to make trades, and one source of data is retail trades on exchanges. These dark pool participants often purchase data from brokerages or get the data directly from the SEC and exchanges themselves in exchange for cash. That new revenue source and monetization of retail-driven trading volatility has lowered transaction costs significantly, to the point where many brokerages now offer free trading.
That is not the only benefit to retail investors, but lowered commissions is a very big deal; many save literally thousands per year thanks to dark pools. Additionally, however, this connection between retail exchanges and dark pools has helped lower the bid/ask spread thanks to the liquidity provided by dark pools; while younger market participants are used to a penny spread between bid/ask for most large cap stocks, in the past spreads were significantly wider. Which brings us to a third benefit to retail investors: liquidity. Now it is easier than ever to sell shares when needed, but in the past it could take hours or even days to sell shares because it was hard to find a buyer. That’s a thing of the past now, even for small cap stocks, and it’s again thanks to the dark pools.
Of course, explaining these things to most investors is difficult, and there is an instinctual revulsion towards the way that trade data is bundled and sold to firms like the high-frequency trading companies that straddle dark pools and exchanges. But those investors need to ask themselves whether they prefer their data being sold and getting free trades or having to pay $10 or more every time they want to sell a share and probably getting a worse price for their shares when they do sell? On balance, the economic value of dark pools for retail investors has been significant.
