Dark pools sound shadowy and mysterious. They’re not for swimming. They’re for buying and selling stock anonymously, away from the peering eyes of other participants in the capital markets. And over the last several years, the use of dark pools has risen substantially.
In fact, the portion of stock trading taking place away from public exchanges – in places including dark pools – has recently hit new highs. It’s amounted to close to 40% on some days this year, up from an average of 16% five years ago, according to Rosenblatt Securities.
So as you watch the stock market go higher, should you be worried about the increase in trading going on in the shadows?
Maybe not if you consider why dark pools exist in the first place.
“The original purpose of dark pools was to create an anonymous environment where large institutional investors could trade among themselves without being front-run and have the prices of those stocks go against them,” says Merrin, who runs a dark pool and is CEO and founder of Liquidnet (“front-runners” include high-frequency traders and other marke participants). “Remember, it’s the institutional asset managers that are managing money on behalf of the hundred million individual investors who entrust them with their pension funds and mutual funds.”
So if the person managing your mutual fund uses dark pools to get you the best price, that’s great, right? The problem, Merrin and others say, is some dark pools have gotten away from their original purpose, with more market players using them to execute even small trades.
One concern is that dark pools could be distorting share prices. Trader Joe Saluzzi says all investors should be worried that markets are no longer allowing supply and demand to determine accurate prices -- what’s known as price discovery.
“What’s happened is the market has become so fragmented with various dark pools and over 13 lit exchanges - ones that actually display quotes– that it’s created a new 'arbitrage dance' as we call it,” says Saluzzi, co-head of equity trading at Themis Trading and co-author of Broken Markets.
It’s an arbitrage dance where some sophisticated players are able to unfairly exploit the system, an advantage others simply don’t have.
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