What Are Dark Pools in Stocks and How Do They Work?

If you haven't heard of dark pool stocks, there’s a good reason for that. A “dark pool” is a private exchange used for trading securities in a non-public manner. The dark pools usually aren't available to the general public. They are more frequently used by large investors like hedge funds.

Public stock exchanges like the New York Stock Exchange and the Nasdaq are heavily regulated and monitored by the SEC. In contrast, dark pools are subject to very little regulation and oversight by any governing organizations. This is why they are also called “dark pools of liquidity.”

Dark pool investing can save institutional investors money since they aren’t managed by a large public exchange and therefore avoid exchange fees. Also, the intentions of their trades aren't public until after the trades are executed, which can also offer a price benefit for an institutional investor.

An institutional investor has a greater chance of selling a large block of a security within a dark pool since it’s already restricted to large investors.

Dark pools are legal trading exchanges that are kept private. They might also be called alternative trading systems (ATS) or private trading networks. As of February 2020, over 50 dark pools were registered with the SEC, falling into three different categories.

The three categories include:

1. Broker-Dealer-Owned Dark Pool—examples include Credit Suisse's CrossFinder, Goldman Sachs's Sigma X, and Morgan Stanley'sMS Pool.
2. Agency Broker or Exchange-Owned Dark Pool—examples include agency broker dark pools Instinet, Liquidnet, and ITG Posit. Some exchange-owned dark pools are those offered by BATS Trading and NYSE Euronext.
3. Electronic Market Makers Dark Pools—these dark pools are managed by independent operators.

The privacy of dark pool stock trading can be helpful in keeping details of large trades away from news media coverage. On the public market, these types of trades would likely “trigger price overreaction or underreaction,” according to Corporate Finance Institute.

Dark pools enable large trades to be broken into smaller pieces and executed before the price drops. These trades are also called “block trades,” and they are so large that they have the potential to impact a security’s price, which is minimized by using the dark pool. This is the main reason dark pools were created.

Dark pool stocks are also used for HFT (high-frequency trading) and might help improve market efficiency. However, there are cons associated with HFT as well.

Certainly, a major negative aspect of dark pools is their lack of transparency. This leaves the dark pools “susceptible to conflicts of interest by their owners and predatory trading practices by HFT firms,” according to Investopedia.

Another con of dark pool stocks is that their trades disproportionately benefit institutional investors over small-time retail investors. The off-market prices can be very different from public exchange prices. Institutional investors might be able to sell large holdings of a security on a dark pool before retail investors are aware of this activity.