What are Forex Dark Pools?

Networks of independently owned trading forums, exchanges, or markets are known as “dark pools,” and they offer a platform for the anonymous trading of securities. Broker-dealer businesses and investors interested in placing orders for the trade of certain securities away from the prying eyes of the public might use dark pools to support non-exchange based trading methods. “Dark pool liquidity” or “dark liquidity” are other names for dark pools.

What is a forex dark pool?

Dark pools are secret exchanges that are not accessible to the general investing public, unlike stock exchanges. Large Wall Street businesses developed them so that their clients could execute anonymously bulk trading orders (block trades).

Dark pools’ primary goal is to help huge investors execute block deals at advantageous prices that, if done on ordinary exchanges, would have a significant market impact. Since high-frequency traders utilise dark pools to front-run big orders and profit at the expense of actual investors, even though the lack of transparency of the dark pools is advantageous to its players, it has recently also sparked some criticism over possible conflicts of interest.

Dark pools, however, can really be advantageous for big investors who want to execute their orders. Let’s think about the choices such an investor had prior to the development of off-exchanges like dark pools. If a shareholder wants to sell 10% of a company’s shares, doing so on a standard exchange would have a substantial market impact and result in the shareholder receiving an unfavourable price for their shares. The market would still be significantly impacted even if the order were divided into smaller portions. As trading intentions are not disclosed prior to order execution and no order books are made publicly accessible, dark pools would offer the optimum execution circumstances for such an investor. On the aggregated tape, transactions are only delayedly reported.

Dark pools were first used in the 1980s, but Michael Lewis’ best-selling book “Flash Boys” recently brought them back into the spotlight. Dark pool operators were portrayed by the author in a very negative light, “You invite a handful to begin Texas Hold ‘Em by informing them that the deck is devoid of jacks or queens and asking them to keep this information a secret from other players.”

Dark pools in the forex market

Dark pools are used by participants in other markets, including as the foreign exchange market, despite the fact that they are typically linked with the stock market. Many participants may go to dark pools to secure somewhat better terms for their trades because the Forex market is naturally utilised for hedging and funding the needs of businesses. Large FX market participants, primarily huge banks, are likewise anxious to prevent market effect, which could work against them when conducting sizable deals.

Dark pools are a remedy for this, and their acceptance in the FX market is growing as a result of their protection from detrimental market effects, confidentiality from rival institutions, and reduced pricing volatility. Large FX participants including Credit Suisse, Deutsche Bank, and UBS currently run their own FX dark pools, and more buyers and sellers of foreign exchange are anticipated to use them in the future.

How do dark pools work?

The operation of dark pools is very similar to that of conventional stock exchanges. To trade securities, buyers and sellers get together. Only that the orders are kept secret and the participants are “big money” establishments. And because of this confidentiality, whatever transpires in the dark pool doesn’t concern the stock market as a whole.

Despite the enormous quantities of blocks being exchanged, another advantage of dark pool trading for its users is that buyers and sellers frequently have matching offers. For instance, there wouldn’t be many purchasers available who would be ready to match a block sell order if it appeared on the public stock exchange because it is primarily used by retail traders and investors.

Why use dark pools?

A dark pool’s principal goal is to give traders access to order fulfilment that adheres to the standards outlined in the National Best Bid and Offer (NBBO) legislation. The best current bid and offer price that is currently available for an exchange-based securities is what the United States Securities and Exchange Commission (SEC) refers to as the NBBO.

For institutional traders who trade huge blocks of securities, having an order filled in accordance with NBBO is very crucial. When the huge order reaches the open market, the pricing of the securities that a public exchange offers may be impacted. The institutional trader is able to realise a desirable price for the trade by processing it privately without worrying about having to pay a premium to the market.

For instance, if investment bank ABC decided to purchase 1 million shares of firm XYZ in order to diversify their stock portfolio, the purchase would probably have an effect on XYZ’s current market value. The trade is executed without causing any unusual volatility in the market, however, if it takes place in a dark pool and is hidden from the trading public.

Dark pools history

Dark pools first appeared in 1980, following the adoption of SEC Rule 19c-3. Any security listed on a certain exchange after April 26, 1979, is allowed to be actively traded outside of that exchange, according to the law. Off-exchange trading in securities was first referred to as “upstairs trading,” and it made up a relatively modest percentage of overall trading activity.

The first dark pool trading facility, called “After Hours Cross,” was established in 1986 by the business Instinet. Customers placed orders on an off-exchange marketplace during the day, and at 6:30 p.m. Eastern Standard Time, an algorithm paired buyers and sellers using the security’s session-ending closing price as the basis for settlement. After Hours Cross enabled market orders to remain private information, in contrast to the public exchange trading of the time, and as a result, acquired favour with particular investor demographics.

The first intraday dark pool, “POSIT,” was developed by the business ITG in 1987. After Hours Cross was well-liked by volume traders. POSIT matched stock trades in accordance with the midpoint of the NBBO rather than using the session’s settlement price as the basis for trade execution. Due to competition inspired by POSIT’s success among investors, the number of organisations interested in offering dark pool trading venues actively increased starting in the late 1980s and continued into the 1990s.

Dark pools trading volume

Off-exchange trading in the US has surged in recent years, accounting for a large percentage of all US stock trade activity. Given that trillions of dollars worth of US stocks are traded, this is trillions of dollars and reflects a considerable increase from previous years. “We have academic research now that demonstrates that, yes, in fact there is a point beyond which the volume of shadow trading for particular securities can significantly undermine market quality,” claims John Ramsay, a former head of the US SEC’s Trading and Market division.

Dark pools and high-frequency trading (HFT)

High-frequency trading and dark pools frequently coexist. High-frequency trading is a type of trading where computers are used to execute a large number of deals quickly in the hopes of benefitting from minute price changes.

The institutional traders make a lot of money from this type of trading, which is why more and more of them have been joining in. Because there were so many of these HFT trades, the law of demand and supply took effect, and prices increased in response to demand.

It became more difficult for regular retail traders to purchase shares and engage in trading as stock prices rose. Then, these HFT traders made the decision to move their operations elsewhere, where they would not have an impact on retail traders and would be less likely to raise prices. The dark pool served this goal admirably.

What are the types of dark pools?

The company that provides the trading venue categorises dark pools. Depending on the market participant’s demographics, each form of dark pool has a distinct trading environment and varied incentives. Each venue aims to increase liquidity and offer a service to traders, however certain aspects of each type of dark pool may or may not be advantageous to all users.

Dark pools can be divided into three categories:

Broker-dealer-owned, agency broker or exchange-owned, and electronic market makers are the three primary categories of dark pools.

Large broker-dealers create broker-dealer-owned dark pools for its clients, and these pools get their prices from order flow. The broker-dealers’ own proprietary traders may also be included in these types of dark pools.

While electronic market makers are dark pools that serve as principals for their own account and are controlled by independent operators, agency brokers or exchange-owned dark pools act primarily as agents and obtain their prices from exchanges.

Dark pool trading strategies

In dark pools, traders employ a range of various methods. Iceberg orders are one such tactic, where only a small percentage of the entire transaction is visible on the open market. Because of this, dealers can fill out huge orders without alerting other market players to their intentions.

“Momentum ignition” is another another tactic that is frequently employed in dark pools. Before making a larger trade, this entails conducting tiny trades to test the market and determine investor interest. This may be a powerful strategy for increasing momentum and the price of an asset.

Are dark pools legal?

Contrary to what their name suggests, dark pools are not inherently forbidden. Dark pool managers, however, have occasionally abused their authority to engage in dishonest or unlawful trading. Credit Suisse paid a fine of more than $84 million in 2016 for trading against its clients using a dark pool. Barclay’s Capital, another operator, forked over $70 million. Dark pools, according to others, should be subject to more stringent regulation because they naturally conflict with one another.

What impact do dark pools have on stock prices?

Dark pools hide huge trades in an effort to lower volatility. Large block sales on the open market typically result in a drop in stock price since they increase the quantity of the security that is accessible for trading. Dark pools enable large institutional investors to make bulk purchases or sales without disclosing information that might have an impact on the wider market.

Dark pool pros & cons

Dark pools’ key benefits include lower transaction costs due to no exchange fees on dark pool trades and a reduced market impact for large block trades, which allows institutional investors to obtain a better price than they would if their orders were executed on standard exchanges.

Dark pools, on the other hand, have a lot of disadvantages. The biggest disadvantage is that because of their lack of transparency, securities may be mispriced on normal exchanges. Unaware investors might overpay for a securities, which could then lose value once the public learns about a sizable dark pool order on that stock.

In his book “Flash Boys,” Lewis emphasised the growing controversy over the potential conflict of interest between dark pool members and the broker-dealers’ own proprietary traders who may trade against the client. High-frequency traders may benefit at the expense of dark pool participants if broker-dealers grant them privileged access to the dark pool.

Dark pools are also removing liquidity from open markets, particularly now that their trading volume has increased. The fundamental issue with this is that open market price discovery is getting harder, which makes transactions more expensive. Lower liquidity on exchanges also causes bid/ask gaps to widen.

Regulation of dark pools

Depending on the country in which they operate, different laws apply to dark pools. Dark pools must comply with the same regulatory requirements as typical stock exchanges, such as registering with the Securities and Exchange Commission (SEC) and disclosing specific operational details, for instance, in the United States.

Dark pools are subject to certain regulations intended to enhance fairness and transparency in the trading process in addition to these general regulatory obligations. Dark pools, for instance, are required to reveal the proportion of trades that were performed at the national best bid and offer’s midpoint, which is a sign of the market’s competitiveness and liquidity.

Final thoughts

Off-exchange trading was first introduced in 1980, and since then it has expanded rapidly. Dark pools now account for a sizeable share of daily trading volumes in financial securities. The use of dark pools for trade facilitation is nevertheless a viable component of the financial system, despite being the subject of considerable scrutiny with a view to reform.

Large institutional investors like banks and mutual funds can benefit from a number of pricing benefits provided by dark pools, and their market share is anticipated to grow in the future. However, regulatory authorities have increased their scrutiny of them due to the lack of transparency, potential conflicts of interest, and predatory trading tactics. If adopted, the SEC’s “trade-at” rule would mandate that brokerages send their clients’ orders to exchanges unless they can find noticeably better rates on dark pools.

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