A dark pool, also known as a liquidity pool, dark liquidity, or dark book, is a private, electronic execution network that collects bids and offers from different traders. An order is executed only if a matching trade is already entered into the pool, in less time and at a better price than if the trade is executed on the exchange.
The dark pools are considered to be dark because -- unlike a public exchange such as NYSE or Nasdaq where the bids and offers are visible -- no one can see the book of orders, although quotes are printed when a trade takes place. Hence, "dark" is not synonymous with "evil" here. Working with a dark pool does not (necessarily) mean that you have joined forces with Darth Vader.
Although these pools are relatively new, the financial markets have always had orders that some traders knew about that were not entered in the books. Floor brokers and market makers often said that they were "in touch with liquidity," meaning that they knew of people who would be willing to buy or sell shares if the price and size available matched their needs. Until then, they would not enter an order.
The bottom line is that the trading floors don't have a lot of human beings anymore. That's why this liquidity information moved from their heads and into the dark pools. And it's been moving at a good pace, too: Rosenblatt Securities, an institutional stock trading firm, tracks dark-pool liquidity and reports that dark pools executed 12.48% of trades in January 2011, up from 10.34% in January 2010. The share of trading through dark pools has been increasing steadily since Rosenblatt began tracking it in 2008.
The advantage of dark polls is that traders have more flexibility in placing orders and reducing transaction costs. If your broker executes your order through a dark pool, the price will be better than if it is placed through the exchange. That's good. However, it also means that there is price and volume activity in the market that is not public until it is executed, and that's not so good. Traders rely on information, and the size and price data in a transparent quote can give someone a sense of where the price of a security is likely to move. If that data is obscured by a dark pool, then a trader has less information to work with and could be blindsided by a sudden move.
For example, maybe a trader wants to enter an order to be executed only in an extreme event, such as a sell order based on a 30% price decline. If the order is entered in a dark pool, it will remain invisible until someone crosses it. If it does happen, though, it may take prices down further when the trade hits the tape, which can lead to more volatility. The Securities and Exchange Commission's position is that prices don't have to be displayed, but firms have an obligation to execute at the best-possible price rather than trade through any one exchange. However, it would like to see more information disclosed after the trade, including the name of the dark pool. Given the other issues that the SEC is facing, though, this is low on its priority list.
This lack of transparency and potential for more volatility led many traders to blame dark pools for the "Flash Crash" of May 6, 2010, in which the markets plunged in a matter of minutes. Federal regulators later blamed the event on a large investor using automated trading software to sell futures contracts.
The irony here is that less-efficient information leads to lower transaction costs. Because the orders in the pool are not disclosed, their mere existence is not enough to move the market. The benefit goes to the parties in the transaction, though, not to the market as a whole.
It's a situation designed to drive an academic crazy, but it's not scary. If you are an active trader, you want to work with a broker that participates in dark pools. The broker will disclose it
and, in many cases, actively promote it for the execution benefits. But when you trade, you need to know that there are orders out there that you won't know about until they are executed, no matter what quotation service you use.
I look forward to more agreeing/butting heads in the future, street smart!
Great analogy between regulators and teachers. It's hard to pay regulators well in a time and country where "big government" is demonized.
Politics aside ... one recent story I know about investors rebelling against opacity: it happened a couple years back, albveit in the small, exotic catastrophe bond market. Before the meltdown, investors weren't allowed to know before investing in a bond what made up its collateral. Why worry ... strong firms like Lehman Brothers were backing up the collateral. Well, when Lehman went down, a handful of bonds nearly imploded and the market froze (like everything else). To the credit of everyone involved in cat bonds, they quickly realized that investors wanted and needed transparency with the collateral arrangements, the market turned around quicker than most any other asset class ... and the market's been happily ever after since. Just had a record issuance in the first quarter.
Hey Broadway...LOL, P.A.! Considering we argue so much we really are in total agreement. I think when the investors rebel against opacity is when heads will roll and things will change. Wish I had more faith that regulators weren't always playing catch up but I just do not.
Right now, regulators are like teachers. We SAY we value them, but we really don't pay them or give them the resources they really need to do their jobs properly.
That has to change if the playing field is ever really going to level.
@street smart, I prefer the initials "P.A."
And you're right, an open free market as simply defined is one where government keeps out and buyers and sellers agree on prices. That's it.
As far as transparency is concerned, if everyone involved in the market is ok with opacity, then so be it. Nasty things tend to go bump in the dark though... And eventually the bumps turn into explosions. Eventually, if it's not regulators throwing up red flags over opacity, it'll be the investors themselves.
Dear Broadway...do you prefer to be called Polly or Anna? Rather than being snide, let me be perfectly, blindingly clear that I think transparency should be the desired goal of our financial markets as well. I DO NOT agree with you on two counts though, one theoretical and one practical.
First, the theoretical. A market does not have to be transparent to be "free." In fact, the very concept of a laissez-faire (literally "leave it alone") market would suggest the opposite--a total lack of legal or regulatory intervention.
Second, the practical. You say "regulation will eventually catch up enough to prosecute the next scandal." By definition there is a gap there--scandal happened in the past, regulations regulate past behavior, markets on to next thing in present and future. It's like trying to hit a moving target and good luck with that. And never mind the embarrasment of the "hide in plain sight" obvious things like the Madoff scandal that regulation has pathetically missed!
But that isn't even the point of the dark pools or my original post. The point I originally made is that aligning oneself with a broker of firm that prides itself on its perfectly legal trading prowess is a good idea. Of course, there's a spectrum of importance here. This matters less if you are a buy and hold investor and matters enormously if you are a day trader.
But I promise you that even Warren Buffet is working EVERY ANGLE to make sure he is getting the best possible price on every trade he makes by working with the best firms and the best brokers through legal means. Why do you think he bought a stake in Goldman Sachs for heaven's sake???
And there is NOTHING about such trading savvy that that will ever be made transparent through regulation any more than any good business person will ever share his or her proprietary business secrets.
So, Broadway, you can come to the party or stay home but don't call the cops just because you've decided you don't like the music they're playing next door.
I did not expect there will be a "flash crash" and believe nobody can predict event like this. It was just pure luck. In the meantime, I had friends who lost his shirt by setting sell limit order to protect his portfolio.
Even without the flash crash, you can catch some good opportunity from time to time. Like I bought GE where it first hit the $13 and BRK-B at $2500.
Recently I read a book and found actually Sir John Templeton used the similar approach to manage his trading.
In retrospect, this strategy is not bullet proof. You may miss opportunity like GE at $8 and BRK-B at $2000. Furthermore, if the company deserves a sharp fall due to serious incident like BP oil leak in the Gulf, you may get stuck in a position for a long time.
Its very interesting that "Dark Pools" are becoming the more and more utlized in the market, as basic human instinct wants to "see" and be exposed to whats going on with the books. But not here, this is a shot int he dark that is truly a risk.
"If you are an active trader, you want to work with a broker that participates in dark pools." I guess that I will try this mehtod out just to see how things pan out.
That is amazing that you did that (if true). You are absolutely correct to think that way. You are taking advantage of extreme events which can actually be beneficial.
Ever since the Flash Crash I have a standing limit order to buy Proctor & Gamble (PG) at 32, though unfortunately my bid has not been hit since and I'm skeptical that opportunity will come again. Next time it will probably not be PG, it will be other stocks, so maybe a system can be built to insert dozens of well-below market value limit orders in for very respectable stocks. I'm sure there are probaly lots of quants that specialize in this.
I am not a trader, but an old fashion value investor. I read the annual report, study the business, and talked to the competitors. Finally I calculate the price I want with a big margin of safety and set a limit order online and go to sleep.
What happened during the "flash crash", all my limit orders were executed. It looked like a gift from Wall Street. I was lucky that I only have several limit orders, otherwise I would have trouble to raise cash to pay the brokers.
There are many explanation of "flash crash". The Dark Pool is an interesting one and sound interesting.
@Street Smart, I guess then the solution if you cannot "find a broker who cares about the "dark trading arts" and work with him or her on a sustained basis" is to get out of the markets?
I agree with @Ashish in that transparency should always be the desired goal of a true free market. Without it, you have no free market. Technology may be outpacing regulation, but regulation will eventually catch up enough to prosecute the next scandal.
I think we're dealing with two concepts here that are being lumped together under the general heading of dark pools. First, the concept of block trading, or large blocks of stock trading at different prices from the rest of the market has existed for decades--certainly long before the NYSE went electronic. Traders at the big firms have always "crossed" their blocks of stock, usually at the very beginning of the day if they wanted to make a statement to the trading community and right at the close if they didn't.
This is different from the ability to place a stop-loss order which automatically triggers the sale of a stock when it reaches a certain price. Now, with electronic trading, that ability has become more sophisticated, so that the parameters can be manipulated to include percentate declines of base values, etc.
BUT REMEMBER...to paraphrase the old saying, bulls make money, bears make money, but ostriches who put their heads in the sand and don't constantly babysit the orders they place WILL NEVER make money! When trading, the race is to the investor who stays on top of his or her broker constantly and has a broker who enjoys staying on top of the trading action. No firm, no matter what they say, is going to let the little guy even close to its program trading action, but if it's a firm that treasures its trading mojo, the little guy may get close enough to the action to draft off the breeze and reap a little reflected benefit.
Also, remember that what can be saved on getting a great trade can be many times greater than nickel and diming a broker over pennies on a commission. Again, find a broker who cares about the "dark trading arts" and work with him or her on a sustained basis.
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There's a relationship between unemployment and inflation. High inflation, high employment. Low inflation, low employment. Guess what you can expect with jobs these days?
For bondholders, it doesn't matter if rates go up because of default, inflation, or economic activity. All that matters is that rates are going up, and that's bad for them.
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