Dark Pools: How Hedge Funds Beat You Every Time
In every great political drama, there’s always a covert meeting between two parties in a secret location. From Woodward and Bernstein to the Underwood’s, the most important conversations are kept under wraps so as to not alert those that might be listening or watching. Would you believe that institutional investors and hedge funds do something similar?
That’s right! Today, let’s cover the topic of “dark pools,” including why they exist and how they might directly affect you, the retail investor.
What Is a Dark Pool?
A dark pool is a legal private exchange between two parties for the purposes of buying and selling securities away from the attention of public markets. Typically set up by the broker-dealer or exchange for the purposes of linking two parties, it’s inaccessible to the public, and the activity within it is completely opaque to people like you and me, hence the “dark” part of dark pool. But why do dark pools exist?
Let's Talk Block Trading
Typically, when an individual investor is buying or selling securities, they are doing it on a relatively small basis. They might be buying or selling a few hundred, or few thousand, dollars worth of securities, which is barely enough to be a drop in the ocean of market activity. However, if an institution wants to move shares, they can do so in great quantities. This can cause a couple of issues, namely price issues from block trading.
Block trading is when a large amount of a security is attempted to be bought or sold at one time, and this type of buying and selling can lead to significant price impacts.
Let’s say that an institution is selling 100,000 shares of their biggest holding. They are suddenly flooding the market with shares, and they risk the price declining as more are sold, resulting in the institution making less money than they bargained for. The opposite can also be true, as buying 100,000 shares at one time can immediately choke the supply, driving the price up higher than the institution would have wanted. This is why dark pools exist.
The Downside of Dark Pools
Supporters of dark pools are quick to point out that these provide liquidity in the markets, giving block trades a safe place to happen so shares are readily available to those who want to buy or sell. However, there are three major issues with dark pools that all hearken back to that term “dark.”
The first is the public market unknowingly mispricing securities available to individual investors. As dark pools are essentially secret transactions, the public markets have no knowledge of them. This means that public markets cannot price the effect of these trades into the prices of readily available securities until the dark pool transaction becomes known. This can lead to wild mispricings of public securities that individual investors are purchasing, essentially beating up on the little guy, which is literally a plot point in Showtime's Billions.
Second, dark pool detection is essentially now a cottage industry for high-frequency trading firms. Like a shark that smells blood in the water, high-frequency traders are now seeking out dark pool activity so they can “front-run” the trades, basically trading on the information they discovered in the dark pool to collect a spread of cash on their own trades.
Third, there is a storied history of dark pool operators misusing and misrepresenting funds and transactions to the general public, as well as to clients. Thanks to the secretive nature of the dark pool, correct information can be tough to come by without an audit, which is exactly what the Securities and Exchange Commission in the United States has been up to. According to The Wall Street Journal, over $300 million in fines have been collected from dark pool operators over the last 11 years.
The Future of Dark Pools
While beneficial for large institutions, dark pools do nothing to help the average individual investor. Fortunately for us, however, the use of dark pools seems to be lessening. While overall trading volume within the pools themselves is still high, the number of shares changing hands is now less than 150 on average, meaning mispricing and high-frequency arbitrage are lessening. Unfortunately, dark pools are starting to rear their heads in a new trading ecosystem: cryptocurrencies.
A previous version of this article was originally published on www.fennel.com.
