Before starts to read, lets know about Dark Pools.
Definition of 'Dark Pool Liquidity'
The trading volume created by institutional orders that are unavailable to the public. The bulk of dark pool liquidity is represented by block trades facilitated away from the central exchanges.
Also referred to as the "upstairs market," "dark liquidity" or "dark pool."
Investopedia explains 'Dark Pool Liquidity'
The dark pool gets its name because details of these trades are concealed from the public, clouding the transactions like murky water. Some traders that use a strategy based on liquidity feel that dark pool liquidity should be publicized, in order to make trading more "fair" for all parties involved.
“Dark pools” is the romantic – or sinister, depending on your viewpoint – name given to networks that allow traders to buy or sell large orders without running the risk other traders will work out what is going on and put the price up, or down, to take advantage of the order. They have been criticised for their lack of transparency and because the inevitable fragmentation of trading could lead to less efficient pricing in traditional open stock exchanges. ( Source: Sophia Grene, Reporter, FTfm, Financial Times )
A type of trading platform that allows large blocks of shares to be traded without the prices being revealed publicly until after trades are completed. (Source: Mary Watkins, Asia ICN Editor, Financial Times)
Pre-trade prices - the price at which shares are offered for sale - are not visible to anyone, even the participants in them, and the price at which shares change hands is only revealed after the trade is done. ( Source: Jeremy Grant, Editor, The Trading Room, Financial Times)
But is the lack of transparency something we should be worried about?
Anyone connected with the banking industry in the past few years can be forgiven for wanting to find a place to hide.
Is it any wonder then that financial institutions all over the world are finding themselves in the dark? Or, to be more precise, in a dark pool. The biggest names in finance are lurking more and and more in these liquidity lagoons.
Dark pools are trading venues where companies deal in stocks away from public stock exchanges (the ‘lit’ market) in an anonymous fashion. They are being increasingly used by banks as they nullify the risk involved through exposure to a fluctuating market.
There are no unexpected peaks or troughs – instead a fixed price is agreed for bulk trading. The price is only announced to the public after the deals are completed.
The popularity of this off-exchange trading is rising. Institutions such as Barclays, Credit Suisse, Morgan Stanley, Goldman Sachs and UBS all have broker-dealer-owned dark pools.
In the US, trading in dark pools accounts for about 13 per cent of all volume, while in Europe they now make up nine per cent of total order book activity, three times as much as in 2010.
In research published this week, London-based investments group the CFA Institute said dark pool trading in the US had grown by almost 50 per cent in three years. In Britain, the London Stock Exchange owns the dark pool Turquoise.
However, there are concerns that the lack of transparency in dark pools will eventually prove harmful to financial markets.
The Australian government is investigating the impact of dark pools on both the integrity and quality of the markets, while tighter regulation is also being discussed in Europe and the US.
Last year, Pipeline, a dark pool in the US, was fined more than $1m for profiting ahead of orders placed by its clients.
This week, former hedge fund manager Mathew Martoma, who is alleged to have been behind the biggest insider trader scheme of all time, valued at $276m (£173m), was arrested in the US. He is accused by the government there of turning to dark pools to get rid of millions of dollars.
‘In the financial industry, dark pools of liquidity is trading volume or trading interest that is not available to the public,’ explained Rhodri Preece, director of capital markets policy at CFA Institute.
‘Orders entered in the dark pool are not displayed to other market participants.
‘Dark liquidity pools minimise the market impact that is associated with trading on-exchange because neither the price nor the identity of the trading company is displayed.’
He said dark pools have existed in some shape or form for decades but that there was another reason for their re-emergence.
‘Advances in technology have enabled these systems to develop and proliferate, becoming cheaper and more efficient to use over time. There are a number of factors why this kind of trading has increased, but technology has been the key enabler.’
He added: ‘Despite the negative connotations associated with the name “dark pools”, they are mostly beneficial for investors and can improve market quality.
‘However, it is important that there is strong and fair competition between traditional exchanges and dark pools, as too much dark trading could damage market integrity.
‘We don’t necessarily need more regulation, but we do need consistent regulation. Dark pools that function in the same way as exchanges should be subject to similar regulations.’
All dark pools regulated as trading venues are supervised by the Financial Services Authority, which said it supported moves in Europe to extend transparency.
‘Regulators across the world are playing catch-up when it comes to dark pools and, unsurprisingly, one of their key concerns is transparency,’ said Elizabeth Fournier, news editor at City AM.
‘Watchdogs are worried that these vast and opaque markets damage price discovery, but have little access to data or case studies that back up their concerns.
‘They’re attractive to asset managers as they lower the risk of prices fluctuating too much during a trade as the market gets wind that a large amount of a stock is on the move.
‘With mainstream exchanges and banks getting in on the action, they’re also a lot more accessible to investors, with independent and brokers also vying for a seat at the table.’
Independent dark pool Liquidnet connects more than 700 asset managers to trading worldwide.
Per Lovén, European head of corporate strategy at Liquidnet, said: ‘Executing trades in a non-displayed trading venue means large orders can be filled while minimising market impact, achieving best execution.
‘Liquidnet estimates that this information leakage drains $50m to $100m from investors’ returns in the US alone.
‘With returns on equity investment stubbornly subdued, this demonstrates that savings in execution costs can make a big difference to overall portfolio performance.’
Wall Street Journal reporter Scott Patterson is the author of Dark Pools: High-Speed Traders, AI Bandits and the Threat to the Global Financial System. He believes dark pool trading is growing here as well as in the US.
‘Dark pools are simply a venue for trading stocks,’ he said. ‘But they have become increasingly complex in recent years as the dark pool operators have attempted to lure more trading outfits into their pools.
‘Firms are attempting to hide from the predatory trading, at times by high-frequency trading firms, that has taken over stock exchanges.
‘The risk is that as more trading takes place in dark pools, it becomes more difficult to find accurate prices for stocks. A dark pool is, after all, dark, and there is a public good to transparent trading.’