What are dark pools?

Equity markets in the U.S. and increasingly around the world work on a participant model in which those wanting to trade will display shares to buy or sell and the asking or bidding prices. At exchanges, these displayed prices by brokers can be seen through what are called “Tier II quotes.”

The opposite of displayed is “dark.” Thus, the term “dark pool” refers to a place where trading liquidity — a supply of shares — exists that is not displayed for all to see. Think of dark pools as members-only platforms for trading participants wishing to execute larger trades without advertising interest through an open-book, or displayed, position.

There are independent dark pools like Pipeline, Liquidnet and ITG Posit, and broker-operated dark pools such as Credit Suisse’s CrossFinder and Goldman Sachs’s Sigma X. The anonymity afforded to investors and trades through dark pools protects not only the parties’ identities, but also the sensitivity of share prices to movement when any sizeable demand surfaces.

Dark pools serve a highly useful purpose. They enable large institutional participants to move sizeable amounts of liquidity without fighting all the trading intermediation that distorts stock prices. Some are concerned that dark pools themselves garble pricing mechanisms and present the risk of a two-tiered market between displayed and dark liquidity. But all markets are two-tiered. For any product, there are wholesale and retail channels. Same with stocks. There are wholesale and retail brokers, upstairs and floor trading. If anything, dark pools are a response to regulatory efforts to create a single market for all participants, which is contrary to human nature and at odds with the diverse purposes and time horizons that typify trading transactions.

Bottom line: dark pools are a natural response to pricing inefficiency and over- intermediation.

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