A dark pool is a stock exchange that is not open to the public, and does not display the liquidity posted to its books to anyone. Dark liquidity is considered any liquidity that executes away from public exchanges. The purpose of trading in dark pools is mostly to minimize a large order’s impact on price. Orders transacting between institutions away from public markets are considered dark liquidity as well, even if they never enter into any established “pool”. While liquidity is not displayed, after an order transacts it prints to the public consolidated tape, and everyone can see that the order transpired. What is not known is which dark pool exchange the order transacted in.
In a public exchange, all of the orders in the book for a stock on the bid and offer are displayed to the public. While this is good for efficient price discovery, it is bad for institutions with large orders to be executed. If an institution with a large order were to put their entire order on the public light pool ECNs, traders would purposely move the price away from the order in an unfavorable direction to the institution (if it is a buy order traders will move the price higher and force the institution to execute at a worse price.) When the NYSE was the exchange executing almost all of the volume, this was a big problem for traders with large orders. Other traders would know the big order existed and would force the price in an unfavorable direction. The market impact of large orders was even greater than the order size alone seemed to indicate. As more volume is transacted on dark pools, it has called into question their role, as having a lot of hidden volume is not conducive to efficient markets.
When an order is entered into a dark pool and there is no contra liquidity to be matched with, it will post on the dark pools books just as if it were a light pool, except the books are hidden from everyone except the pool owners. When another order enters into the pool it is crossed with the sitting contra-direction liquidity and is executed. The order executing in the opposite direction of the large order will be completely filled just as if it was executed in the light pools, but unlike the light pools the trader behind the smaller order will not know the true extent of liquidity in the pool, only that it is greater than his order.
This is known as the “winners curse”. This is because it can be assumed that if the order was filled completely, there is a good chance that it would have been more beneficial to let the larger order impact the market first because the larger order will have a bigger price impact than the smaller order. In reality it is usually a mixed blessing because there are a lot of players transacting in most securities and new liquidity is always entering into the pools. It should be known that there are regulations preventing most orders from executing away from the national best bid and offer, so a dark pool cannot prey on unsophisticated traders. However, most traders acting in the dark pools are very sophisticated.
There are also different types of dark pools, and depending on the pool type it may change the participant’s idea of the quality of a fill. For instance, some pools will only match client orders against other client’s orders. Having an order completely executed in a pool of this nature is more likely to be viewed in the “winners curse” context.
Other dark pools are owned by broker deals, and the broker dealer will act as a counter party to the order if there is not enough other contra client liquidity to match the full order size. A fully filled order with a broker dealer counter-party is often a high quality fill, because the broker executed the order from their own share balance simply to provide high quality execution.
This type of dark pool relationship is very important to How We Trade, and we utilize this execution very frequently to get more liquidity at better prices than would be available otherwise. Our broker dealer dark counter-parties are one of the biggest edges we can offer a trader, and because we transact so much volume with these broker dealers our execution costs are comparably very low.
There are times where certain price levels will have vastly more liquidity available in the dark pools than on the public exchanges, and vice versa. Volume has generally trended toward more execution in dark pools over the last few years, meaning a higher percentage of total volume executes in dark pools now than in previous years. This means that traders need to educate themselves and trade with firms providing next generation execution like How We Trade, or risk being left with inferior tools.
Types of Dark Pools and Their Impact on Execution Quality
Dark pools come in different types and the type of dark pool can impact the quality of the trade execution.
Some dark pools only match client orders against other clients’ orders.
In these pools having an order completely executed is more likely to be viewed in the context of the “winners curse.” Other dark pools are owned by broker-dealers and if there isn’t enough client liquidity to match the full order size the broker-dealer may act as the counterparty to the order.
A fully filled order with a counterparty broker-dealer is often considered a high-quality fill because the broker executed the order from its own share balance to provide efficient execution.
How We Trade frequently utilizes this type of execution to access more liquidity at better prices.
This relationship with broker-dealer dark pools gives us a significant edge and helps keep our execution costs low.
Traders need to be aware of the different types of dark pools and work with firms that offer next-generation execution to ensure they have access to the best tools for their trades.