Dark Pool Liquidity

What Is Dark Pool Liquidity?

Dark pool liquidity is the trading volume created by institutional orders executed on private exchanges; information about these transactions is mostly unavailable to the public. The bulk of dark pool liquidity is created by block trades facilitated away from the central stock market exchanges and conducted by institutional investors (primarily investment banks).

Dark pool liquidity is also referred to as the upstairs market, dark liquidity, or dark pool.

Understanding Dark Pool Liquidity

The dark pool gets its name because details of these trades are concealed from the public until after they are executed; these transactions are obscure like dark, murky water. Some traders who employ strategies that are partially based on the liquidity of the market feel that information about dark pool liquidity should be made available to the public — and not kept secret — in order to make the stock market more transparent for all parties involved.

With the advent of high-speed computer programs, capable of executing algorithmic-based programs in a matter of milliseconds, high-frequency trading (HFT) has come to dominate the daily trading volume of the market. HFT is a method of trading that uses powerful computer programs to transact a large number of orders in fractions of a second; in general, traders with the fastest execution speeds are more profitable than traders with slower execution speeds.

With HFT, institutional traders can execute their massive orders — oftentimes multimillion-share blocks — ahead of other investors, allowing them to capitalize on fractional upticks or downticks in share prices. As soon as subsequent orders are executed, HFT traders can close out their positions and almost instantly obtain profits. This can occur dozens of times a day and can result in huge gains for HFT traders.

In the 1990s, HFT became so pervasive that it grew increasingly difficult to execute large trades through a single exchange. Because large HFT orders had to be spread out amongst multiple exchanges, the transactions inadvertently alerted trading competitors. Trading competitors would try to get in front of each other, racing to become the first place the order; this had the effect of driving up share prices. And all of this occurred within milliseconds of the initial order that was placed.

In order to avoid the transparency of public exchanges and ensure liquidity for large block trades, several of the investment banks established private exchanges, which came to be known as dark pools. Dark pools are a type of alternative trading system (ATS) that give certain investors the opportunity to place large orders.

For traders with large orders who are unable to place them on the public exchanges — or who simply want to avoid telegraphing their moves to their competitors — dark pools provide a market of buyers and sellers with the liquidity to execute the trade. As of February 2020, there were more than 50 dark pools registered with the Securities and Exchange Commission (SEC) in the U.S.

Criticism of Dark Pool Liquidity

Although they are legal, dark pools operate with little transparency. As a result, both HFT and dark pools are oft-criticized by those in the finance industry; some traders believe that these elements convey an unfair advantage to certain players in the stock market.

For one, critics point out that that the lack of transparency in dark pools can hide conflicts of interest. The SEC has also stepped up its scrutiny of dark pools as a result of complaints of illegal front-running. Front-running occurs when an institutional trader enters into a trade in front of a customer’s order because the change in the price of the asset will likely result in a financial gain for the broker. 

On the other hand, advocates of dark pools insist they provide essential liquidity, and thereby allow the markets to operate more efficiently.