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Dark Pools: Are Markets Unfair?

By Krishi Kishore

When we think about stock exchanges, the ones that may typically come to mind include the New York Stock Exchange (NYSE), the Nasdaq, and the Financial Times Stock Exchange (FTSE). However, what if there were stock exchanges that operated completely separate from these typical exchanges and accounted for about 40% of daily trading volume in the United States?

In fact, there are—dark pools are restricted exchanges that retail investors do not have access to, where institutional investors like banks, hedge funds, and endowments are able to purchase and sell large quantities of shares without public exposure. The first dark pools were created in 1980 when the Securities and Exchange Commission enacted Rule 19c-3, which stated that a security could be traded in an exchange that was different from the original listing exchange. Today, there are about 45 dark pools in existence with some of the most well-known institutions in finance such as Goldman Sachs, JPMorgan, and Citadel all operating dark pools for their clients.

Proponents of dark pools justify their necessity by arguing that they regulate volatility in the market. Dark pools are designed for institutional investors, who typically trade in larger volumes than retail investors. As a result, these types of transactions can tend to have substantial impacts on the market price of securities. If very large transactions were revealed to the public, market sentiment could sway substantially in either direction, resulting in sharper price changes. Although the original intent of the creation of dark pools was for trading millions of securities at once, today the average transaction size is in the hundreds, similar to the average transaction size in public exchanges.

Skeptics say that dark pools pose a threat to retail investors as the price of a security on a public exchange may not be reflecting the true market price of the security. Considering the significant proportion of trading volume occurring through dark pools, large transactions of securities by institutional investors are not factored into the public’s evaluation of a security, which could influence the price of a security after a retail investor has bought or sold it. This leads to potential losses or gains that retail investors have now missed out on. Additionally, some say that trading in dark pools could be a conflict of interest. In public exchanges, all the trades for a given security are competing with one another. However, since dark pools are separate from public exchanges, trades in them often do not compete with other trades, which allows for prices to be manipulated.

In the past, dark pools have been met with controversy. One example of this was in 2014, when New York Attorney General Eric Schneiderman filed a lawsuit against Barclays for misleading their clients regarding the proportion of predatory high-frequency traders (HFTs) operating within their dark pool Barclays LX. For context, dark pools are often used by HFTs to optimize for the fast speeds necessary for their trades and the lower fees. However, HFTs have been able to get ahead of hidden trades within dark pools, leading to predatory practices. Two years later, Barclays settled the lawsuit with fines of $35 million to the SEC and $70 million to the New York Attorney General. Similarly, in 2015, UBS settled with the SEC for $14.5 million for allowing HFTs to jump ahead of other clients by trading on prices that were fractionally higher or lower with prior knowledge of the way the dark pool ranked orders.

Understanding the costs and benefits that come with dark pools begs the question, should dark pools continue to exist? The growth of trading in dark pools has been rapid as in 2010, only 16% of trade volume took place in dark pools. Much of this rapid trading volume growth has been attributed to HFTs joining dark pools over public exchanges. However, this has been counter to the original purpose of dark pools as they were designed to protect institutional investors from HFT front-running, or when information about an upcoming trade gets used to execute a trade earlier than the original party. If the growth of HFT dark pool trading continues, then it may be necessary for more regulation of dark pools to ensure their existence still serves a valid purpose. However, if dark pools ceased to exist entirely, we would expect to see much more volatility in the markets as larger trades would be forced to go through public exchanges. Finding an optimal balance between tradeoffs for retail and institutional investors will be vital to guiding the policy discussion around dark pools.

Going forward, dark pools will provide institutional investors an unfair advantage over retail investors to mitigate losses and capitalize on volatility in the market, especially during periods of market instability. For example, during peak market volatility in January of 2021, the vast majority of dark pool trades, which composed 38% of market volume, were executed by just seven companies. This goes to demonstrate how monopolistic the existence of dark pools tends to be for institutional investors, who don’t have to face the drastic fluctuations in security pricing that retail investors cannot overcome. Additionally, retail investors are unable to react to very large trades lined up in dark pools, but institutional investors can. Eric Hunsander of Nanex Research found empirically that HFTs are able to benefit from trades queued in dark pools as they can modify their trades in public exchanges in anticipation of market-moving trades. This luxury is not available to typical investors, supporting the argument in a fairness discrepancy between institutional and retail investors.

The future of dark pool regulation will need to rely on ensuring no significant unfair advantage is created for institutional investors relative to retail investors, particularly by investigating illegal activities like insider trading both broadly and in the context of HFTs, who are capable of acting in public exchanges on non-public information. This will ensure dark pools are still addressing the original problems they were designed to address like market stability while creating no significant unfair advantage for institutional investors relative to retail investors.

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