Dark Pools – How Invisible Orders Control the Market

In stock markets, the benchmark is considered the transparent trading model, where orders are visible in the spreadsheet and price information is distributed symmetrically. In practice, however, alongside the "open" market, its dark counterpart operates – the so-called dark pools, or private trading platforms, where transactions take place outside of major exchanges. These are where large institutional orders can be executed out of the public eye. Critics point out that limited transparency can distort the price discovery process, while proponents emphasize that dark pools create a space for large transactions on more favorable terms, difficult to achieve on the public market.

In this article, we explain what dark pools are, how they work, who uses them, and what their advantages and disadvantages are.

What are dark pools?

Dark pool is a type of private platform for exchanging financial instruments that operates parallel to official exchanges. Formally, dark pools are classified as alternative trading systems (ATS) and are not full-fledged exchanges like the NYSE or NASDAQ, which means they are subject to less transparency and regulatory oversight. The name "dark" refers to this lack transactional transparency, because unlike in the open market, the order book in dark pools is not publicly visibleDark pool participants (usually large institutional players) place buy or sell orders anonymously, and information about these offers is not published on publicly available exchange spreadsheets. Only after the transaction is executed are the details disclosed in post-trade reporting systems (i.e., prices, volumes, and execution times are published with a certain delay). As a result, Dark pools allow trading of large blocks of shares in secret, which is particularly useful when executing large-volume block orders.

Dark pools were created to solve a specific market problem: the disclosure of a large order on the stock exchange can significantly move the price of the instrumentFor example, when an institutional investor wants to sell a million shares, placing such an order on the public market often results in a price drop before the transaction takes place, as other participants, seeing the large supply, begin selling or withdraw their buy orders from the order book. Dark pools help prevent this. Orders in dark pools remain invisible to the rest of the market until they are executed, thus avoiding panic or front-running (preempting orders) by trading algorithms.

How do dark pools work?

The mechanism of operation of dark pools is somewhat similar to a traditional stock exchange, with the difference that the entire process is carried out secretlyParticipants send orders to the ATS system, where they are internally adjusted by the dark pool operator's algorithms. Transaction prices are usually determined based on current market prices – often as the middle point between the best bid and offer (midpoint of NBBO) from the public market, which guarantees that transactions take place at prices close to market prices. This means that the dark pool does not "falsify" valuations - it uses an external reference point, but itself the process of placing and matching orders is invisible for bystanders.

When there are matching buy and sell offers in the dark pool, the transaction is completed without disclosing the identity of the partiesOnly after the transaction is completed does the information reach the consolidated tape as an OTC (over-the-counter) report. In practice, the rest of the market learns ex post that, for example, a block of 500 shares changed hands at price X, but they haven't had a chance to see or react to this offer beforehand. This type of trading significantly reduces the market impact, i.e., the impact of a large order on the price.

It is worth emphasizing that Dark pools are not completely unregulated – transactions must be reported after the fact, and operators of these platforms should ensure fair order matching. Technologically, a dark pool is often simply electronic transaction network integrated with brokerage systems. Modern smart routing algorithms at most major brokers search available dark pools for hidden liquidity before sending orders to the public exchange. This means that if a better price is available somewhere in the hidden system, the investor's order can be silently executed there, with the remainder released to the public market.

Who uses dark pools?

The primary users of dark pools are large institutional investors: pension funds, mutual funds, hedge funds, investment banks, and large brokerage firms. These are entities with large holdings of shares that want to trade quietly. From the perspective of these investors, dark pools offer the opportunity to enter or exit large positions with minimal impact on price.

An equally important group of users are market makers, often affiliated with large banks. In fact, most dark pools are run by large investment banks or specialized brokerage firms. According to various sources, there are currently over 60 dark pools operating in the United States alone, many of which belong to giants such as Credit Suisse, Goldman Sachs, and Morgan Stanley. Brokers often create their own internal dark pools to execute client orders within the company—a form of order internalization that also conceals trading from the public market.

Individual investors typically don't have direct access to dark pools, although they can use them indirectly. If a retail client places an order with a large brokerage house, there's a chance their order will be executed in the dark pool operated by that entity or transferred to an external dark pool if that's more advantageous. However, the "typical Joe" doesn't see the depth of the market in the dark pool and can't place an order there on their own—this happens through the brokers' infrastructure.

It is worth noting that some companies also participate in dark pools. high frequency trading (HFT). Although dark pools were originally intended to protect large investors from HFT algorithms on public exchanges, some dark pools allowed HFT firms to operate on their systems, which sparked controversy. For example, the Barclays LX dark pool was accused of allowing HFT traders to use hidden orders despite promises, a scandal that ended in a high-profile lawsuit. lawsuit and penalties. Generally speaking, however, Financial institutions with large portfolios play a key role herefor whom the benefits of hiding their intentions can be significant.

Advantages of dark pools

Dark pools were created to solve specific problems and offer tangible benefits to large investors. The most important advantage is the aforementioned limiting the impact of large orders on the marketBy keeping orders confidential, an investment fund buying or selling a large block of shares can do so at a price close to the market price, avoiding the effect where its own order worsens its price (so-called slippage).

Another advantage is anonymity and discretionIn a dark pool, neither the order size nor the identity of the buyer or seller are revealed before the transaction is finalized. For financial institutions, this protects their investment strategy. For example, if a reputable fund began buying shares of company XYZ on a large scale on the open market, other players could notice and drive up the price (known as momentum ignition or front-running). In dark pools, the fund can operate without the risk of the market "sniffing out" its intentions.

Dark pools also provide better conditions for order execution in certain situations. They often allow for lower transaction costs. Sometimes they offer price improvement relative to the best public market offers – for example, executing a transaction exactly at the midpoint price can be more beneficial for both parties than standard quotes, where one party must concede the spread. In this way, a dark pool can create a win-win situation for the buyer and seller of a large block of shares.

From the viewpoint of market liquidity, dark pools obviously increase it. They enable the meeting of hidden supply and demand that would not otherwise appear on the exchange's order book. Dark pools thus add depth to the market, but this depth is invisible. This is a common argument raised by proponents of this "invention," who argue that thanks to this the overall accessibility of the market for large entities has increased and price volatility caused by large transactions has decreased. As a result, large investors are more willing to trade, which indirectly promotes market efficiency (at least to some extent).

Dark pool disadvantages and controversies

Despite the advantages mentioned, dark pools are controversial. The most frequently cited problem is lack of transparency, which may undermine the principle of equal access to information. Because orders in dark pools are not publicly visible, other market participants (especially retail investors) are in a worse positionbecause they don't have knowledge of the full picture of supply and demand. In an extreme case, when a significant portion of trading moves to dark pools, prices on public stock exchanges may no longer reflect the actual balance of powerThe greater the percentage of volume that is traded outside the public market, the less certainty there is that the exchange rate is "fair."

Individual investors may sufferfor which the lack of insight into the hidden volume means potentially worse transaction pricesFor example, a retail investor placing a buy order on an exchange may be unaware that someone is simultaneously selling a large pool of shares at a slightly lower price in a dark pool – if this offer were to be released to the public market, they could buy at a lower price. Ultimately, transactions from dark pools are reported, so they impact the market with a delay, but retail investors learn about them after the fact. Public debate has raised allegations that Dark pools favor “insiders” at the expense of “ordinary” investors, creating a sort of two-level market, with a privileged, invisible trading floor for the chosen few.

Another aspect is conflict of interest and potential abuse by dark pool operatorsThese are often banks or large brokerage houses that also serve clients placing orders. The temptation arises to favor some participants over others or use information about dark pool orders in slightly different ways, for example, for front-running or selling this information to HFT firms. For example, ITG (the operator of the POSIT dark pool) was forced to pay a record fine for secretly operating a so-called prop trading unit within its own dark pool, effectively trading against clients. Oversight of dark pools is more difficult, and the lack of transparency creates room for abuse.

Market fragmentation This is another drawback often attributed to the growth of dark pools. The more transactions move off the main exchanges, the more fragmented trading becomes. Participants must monitor many different venues (exchanges, numerous dark pools, internal platforms) to get a complete picture of the market situation (which is difficult or often simply impossible). Public exchanges are losing volume to hidden platforms (currently, days are often recorded where 50% of all volume on US markets was held in dark pools, although the exact figures depend on individual trading sessions), which is sometimes criticized as an erosion of the central place of price discovery. Therefore, traditional exchanges and some regulators view the growth of dark pools unfavorably, fearing market efficiency and integrity as a whole.

The last but not least important issue is access of HFT algorithms to dark pools and the associated risk to users of these platforms. If HFT algorithms are allowed into dark pools, they may attempt exploit delays or non-public informationFor example, the algorithm could send minimal test orders to various dark pools to detect the presence of a large order (called pinging) and then use this knowledge in the public market before the dark pool transaction is made public.

Advantages vs. Disadvantages of Dark Pools Source: Own study.

Summary

Dark pools have become an integral, albeit controversial, part of modern financial markets. These "invisible exchanges" allow major players to execute large-scale transactions without revealing their intentions, bringing benefits such as reduced price influence and better execution conditions for large orders. At the same time, however, hidden trading raises questions about market transparency and fairness, because when a significant portion of trading takes place outside of a major exchange, it is more difficult to assess whether stock prices reflect full information. Institutional investors value dark pools for the ability to discreetly execute strategies, while retail investors may feel some discomfort at being blinded to much market activity.

Statistics show two parallel worlds: in the USA more than half of share trading today takes place outside stock exchanges, indicating the growing role of dark pools in market trading. Examples of dark pool operators include investment banks (Goldman Sachs, Credit Suisse, JPMorgan, Barclays) and independent trading platforms (Liquidnet, ITG Posit), which have collectively moved a significant portion of stock trading to the secret sphere.

It is crucial for investors and stock market observers to understand that beyond the visible order book there is a parallel, hidden dimension of trade, which has a real impact on prices and liquidity in global financial markets.