Despite the mysterious name, dark pools are simply private, non-public exchanges.
When large traders want to offload or buy up large amounts of assets without telling everyone else what they’re doing and so moving the price, they use dark pools.
They allow investors to trade anonymously. This reduces the chance that other market participants will find out about a buyer or seller’s intentions and move the price against them.
On mainstream stock or cryptocurrency exchanges, order books — the buys and sells made by traders -- are available to the general public. This means that price discovery is relatively simple for the small retail trader and he is not duped into buying a share at a higher price or selling at a lower price than is available on the market. Dark pools are private, so their order books aren't made immediately available, but they still have to report all trades, so to say they conceal price discovery is not exactly correct. In 2014 Wall Street watchdog FINRA made dark pool reporting available to the public on a seven-day delay.
“In the past, off-exchange trading was usually done between two brokers over the phone, in a legal practice called ‘upstairs trading’,” explains the New York Stock Exchange in a blog post.
“As technology and regulations changed, large institutional broker-dealers created their own ‘alternative trading systems’ or ‘dark pools’ to conduct these trades. Dark pools and dark trading is legal, but dark pools are not subject to the same rigorous regulations as licensed exchanges.”
Only the very largest investors use dark pools. Think of asset managers tasked with investing millions for banks, hedge funds, and pension funds, or broker-dealers, OTC trading desks, family offices or market makers.
Equity market dark pools are usually run by investment banks. They have gained a poor reputation in recent years after repeat SEC investigations found these banks misled their customers over how trades were executed or who was taking the other side of trades.
In 2016 CitiBank paid $12m to the SEC to settle a probe, Deutsche Bank paid $37m, Barclays laid out $70m and Credit Suisse handed over $84m after promising investors they would have access to “vast liquidity” in its dark pool, which did not materialise.
In 2018 Nasdaq and FINRA increased fees to $3.5m a year in a bid to combat poor banking practices.
Why do institutional investors use dark pools?
An institutional fund, we’ll call them Fund A, believes the Bitcoin price will go down. Fund A wants to sell $1 million of Bitcoin in anticipation of this downtrend.
The first problem is: selling $1m-worth of BTC on Binance, Coinbase or any other open cryptoexchange will send a huge sell signal to the market.
The second problem is: there’s not enough liquidity (enough buyers on the other side of the trade) to sell $1 million immediately at the price they want to sell it at. So they might have to break up that sale and sell $50,000-worth at a time, 20 times in a row.
This means that:
They’ll get charged fees on all 20 sales, and
The huge sell signal sent to the market will push retail investors to sell as well, sending the price trending quickly downwards.
By the time all 20 trades of $50,000 have gone through, Fund A won’t get $10,000 for each BTC they sell, but perhaps $9,500, so their sale ends up being rather more expensive than if they could do it all in one go.
If Fund A could use a dark pool instead of selling on the open market, there’s a much greater chance they’ll be able to keep more of their money (and they’re playing with other large investors’ money too, remember).
UK exchange Kraken was the first to market in 2016 with an Ethereum dark pool. CEO Jesse Powell noted: "Dark Pool trading allows for orders to be placed out of sight so that traders can make large buy or sell orders (minimum of 50 bitcoin or 2,500 ether) without revealing their sentiment to other traders. Advantages include reduced market impact and better price for large blocks.”
While the US and UK have some of the largest public markets for cryptocurrency investors, small island nations like Malta, Gibraltar and Bermuda have moved quickly to take advantage, and businesses will often register there to take advantage of crypto-friendly policies.
Bermudan Prime Minister David Burt has been extremely forward thinking and in March 2019 Omega One’s Dark Pool won one of the country’s first digital asset licences. According to Omega One: “We are now on-boarding select institutions, liquidity venues, and market makers with trading volume over $10m a month.”
Most mainstream equity dark pools won’t make it obvious how much you need to be a part of this off-the-books system. It’s like the old luxury goods maxim: “If you have to ask how much, you can’t afford it.”
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