For many investors, stock trading is synonymous with the chaotic action on the floor of the New York Stock Exchange—the brass bell and traders in blue, yellow and gray jackets barking customer orders.
Reality: Every trading day, approximately 40% of all US stock transactions occur on silent exchanges that most people don’t know about and small investors don’t have access to. The trades are conducted over private electronic networks known as “dark pools.” While the name sounds nefarious and the lack of transparency has caused controversy, dark-pool trading actually may benefit your investment portfolio.
HOW DARK POOLS WORK
Dark pools are exclusive markets where big Wall Street players—institutional investors, hedge funds and managers of pensions and 401(k) assets—trade massive blocks of stock. By keeping these huge transactions invisible and not broadcasting their strategies to the wider market, the trades get the best prices. Example: A money manager runs a multibillion-dollar mutual fund and wants to sell a million shares of a stock. On a traditional public exchange, offering that big a trade would instantly draw competitors and create downward pressure on the stock price before the money manager can unload all his/her shares. (Conversely, a large buy order placed on a public exchange could signal that the stock is in great demand, causing the price to rocket upward before the order is fully filled.) Result: The fund manager gets a less efficient and satisfactory price when he trades the stock.
Dark pools function like traditional public exchanges in that they bring buyers and sellers together. But all the normal pre-trade data for dark-pool stocks (price and size of buy and sell orders, etc.) remain hidden. Data about the trade is not made public until after the trade is completed.
Dark pools have been legal since the 1980s. They really began to proliferate in the early 2000s as Wall Street traders utilized high-tech computers to trade billions of shares a day. Now there are more than 60 of these alternate off-market exchanges in the US, and they have become an integral part of the market structure for publicly traded stocks.
While dark pools may sound like the Wild West of the financial world, many are operated by reputable financial institutions such as Morgan Stanley, Goldman Sachs, Bloomberg LP and even the New York Stock Exchange itself. Dark pools are regulated and monitored by the Security and Exchange Commission (SEC), and all completed trades must be reported to the Financial Industry Regulatory Authority (FINRA).
Downside of Dark Pools
Many critics argue that any potential trade, especially a large one, is relevant information that retail investors on traditional exchanges deserve to know about to ensure market fairness and accurate stock pricing. Dark-pool operators have been fined more than $200 million by regulators for wrongdoings, including leaking information about hidden customer orders to traders outside the private network and giving special access to high-frequency traders who use complex algorithms to trade thousands of times a day and sometimes hold stocks for just seconds to exploit tiny price discrepancies.
As dark pools have become more popular, the SEC has tightened regulations about how they function. Dark-pool operators now must reveal more about their fees and how they match or prioritize orders. Also, all dark-pool trades must be executed at prices at least as good as the best price publicly available.
Caveats for Small Investors
There’s no advantage to trading in a dark pool yourself because the amount of shares you plan to buy or sell won’t influence other investors or disrupt the price you can get on a public exchange. But if you own shares in a large mutual or exchange-traded fund or have a pension plan, it is likely you have gotten better performance as an indirect participant in dark pools.
Dark poolsare a reminder about how wildly stock prices can fluctuate on public exchanges in the course of just seconds. If it’s important for you to get a particular price when you trade a stock, consider using a limit order or stop-loss order.
