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.