Dark Pools

The “dark pool” — a somewhat mysterious, even ominous, term — is the name given to a market structure that has become an integral part of the traded financial markets of the twenty-first century. While on the surface the concept of a dark pool might sound threatening, reality is fortunately rather different: such pools convey a range of benefits to both buy-side investors/traders and sell-side brokers and dealers, contributing to rapid growth in a relatively short period.

In Chapter 1 we introduced the concept of dark liquidity and the reasons why it has expanded and developed in recent years. But dark liquidity does not exist on its own — it is part of an entire spectrum of trading liquidity which is built atop specific market microstructures. In this chapter we take a broader perspective on the topic of liquidity and secondary trading in securities, starting with a review of the need for market liquidity and the issues of market impact and information leakage in relation to block liquidity. We will then explore market microstructure, focusing on orders as the fundamental instructions to buy and sell securities and markets as the forums that combine these orders and match buyers and sellers. We will conclude with a discussion of liquidity supply and demand, considering key parameters such as immediacy, depth, breadth, and resiliency. Note that some of these topics will contribute to our discussion of pricing and execution in Chapter 4.

The trend toward of-exchange dealing has been accelerating in recent years, thanks to the catalysts we have described in the previous chapters. In this chapter we explore in more detail the general characteristics of dark pools, the mechanisms within established exchanges that create dark liquidity, and the venues that are partly or solely dedicated to fostering dark liquidity. Before embarking on this discussion, let us recall the key mechanisms for pooling or accessing dark liquidity noted in Chapter 1, as these will form the core of our discussion below: We will also consider these efforts in terms of hybrid business structures and briefly review the importance of understanding the profile or character of a dark pool. The main point to bear in mind is that dark pools are quite heterogeneous; each structure and venue operates in a slightly different manner, using different forms of technology and following different kinds of business models in order to service a specific segment (or segments) of the client base. Though common strategies may exist at an overall level, each dark platform is ultimately a unique creation.

Pricing and execution are essential ingredients of every financial product and market. In order to create a viable and enduring market, participants must derive some form of economic benefit, or interest will soon wane. Equally, for a transaction to be of use, it must actually be executed — it is pointless to submit orders that go unfilled or are rerouted so of en that the speed advantages of the marketplace are lost. The same applies within the dark pool sector, where it is critical for clients to derive cost savings and venues to generate revenues, and for orders to be filled efficiently.

To continue with our micro themes, we turn our attention from pricing and execution to trading. The visible and dark markets must be seen as a compendium of individual, sometimes competing, trading strategies. This means that the performance of any one strategy affects all others — there is a mutual dependency and relationship. Performance of such strategies is also market-dependent: a quiet and thinly traded market may favor certain approaches, while a fast market with heavy volume may favor others. The most sophisticated players use this knowledge to adjust their trading strategies accordingly. They also consider very carefully where strategies can be executed to greatest effect — in the lit markets, the dark markets, or some combination of the two.

The technology and architecture used in the dark sector is critical to the success of any single venue, and of the market at large. We have briefly noted in Chapter 1 the seminal role played by technology in helping advance of-exchange crosses from the manual/phone-driven processes of the late 1990s, to the automated processes that are so common today. Absent this technological progress, the market would still be in a relatively nascent state and feature much smaller pools of of-exchange liquidity (perhaps approximating those of the upstairs market of the 1980s and 1990s).

Regulation is an essential component of any well-run financial system, and a robust system of rules and controls can add a degree of comfort to all stakeholders — investors, issuers, intermediaries, government authorities, and the public at large. In fact, national markets that feature a strong regulatory framework are generally better placed to attract and mobilize capital and ensure efficient funding and risk management than those lacking such controls.

Throughout this book we have discussed the micro and macro issues of the dark pool sector by reflecting a bit on history, development, evolution, structure, practice, and architecture. In this concluding chapter we will look ahead, speculating on what the future may hold by considering the pros and cons of dark pools and how these might affect the future of dark pools in the marketplace. We will follow this with a discussion of some of the potential trends that might impact the dark sector in the coming years.