Dark Pools Explained

Dark pools are private exchanges that allow traders to transact large orders without publicly revealing their intentions, reducing their impact on market sentiment. Matching trades based on the average of the best available bid and ask price results in price improvement. However, there are disadvantages, including a conflict of interest, a detrimental effect on market prices, vulnerability to HFTs, and smaller average trade sizes. Decentralized dark pools are also available in the crypto trading world, providing secure digital verification methods and fair market pricing.

What Is a Dark Pool?

Dark pools are private venues that enable the exchange of financial instruments. They differ from public exchanges as they lack a visible order book, and trades are not publicly visible until they have been executed. Liquidity in dark pool markets is referred to as dark pool liquidity. Most dark pool trading is carried out in block trades, which involve large volumes of an asset being transacted at a predetermined price.

Dark pools were first introduced in the 1980s, and since then, institutional investors who trade large numbers of securities have mostly used them. The advantage of dark pools is that they enable institutional investors to place orders and make trades without publicly revealing their intentions first. This is beneficial as their intentions to buy or sell large amounts of an asset could negatively impact their trade before they execute it. Dark pools have grown to become a significant component of the global equity markets.

Advantages of Using a Dark Pool

• Dark pools provide several advantages to traders, including reduced impact on market sentiment, price improvement, and no slippage. Traders looking to transact large orders can hide their intentions from the wider investing public, which minimizes their impact on market sentiment.
• In addition, the matching of trades is often based on the average of the best available bid and ask price, resulting in both the buyer and seller getting a more favorable trade than they could on the open market. This is known as price improvement.
• Furthermore, since most of the trading in dark pools is carried out in block trades at predetermined prices, traders can be confident that they will be able to execute their entire trade at the intended price, avoiding any slippage.

Dark Pools Disadvantages

• Conflict of interest: Since the order book is not visible, there is no assurance that trades were executed at the best possible price. If the institution facilitating the trade has a conflict of interest, it can obscure real market prices.
• Detrimental effect on market prices: If most trading occurs in dark pools, public exchange prices may not reflect the actual market. This hinders the free flow of information that is crucial in investing and trading.
• Vulnerability to high-frequency traders (HFTs): Dark pools can be an ideal platform for predatory practices by HFTs. If they have access to order book data, they can front-run large orders and take advantage of unsuspecting traders. Pinging is another method that enables them to map out areas of liquidity and gain an edge over the market.
• Smaller average trade size: Dark pools have seen a significant decrease in the average trade size since their emergence in the 1980s. This indicates that not only financial institutions trading large sizes use dark pools anymore. This may make their existence less compelling and possibly detrimental to the broader market. It may lead to a healthier market if smaller orders are executed in exchanges with a publicly visible order book.

Decentralized Dark Pools

In the world of crypto trading, similar to traditional equity markets, dark pools are available on some trading platforms. Decentralized dark pools have the added benefit of more secure digital verification methods and fair market pricing for all participants without the possibility of price manipulation.

For trades involving multiple blockchains, cross-chain atomic swaps can facilitate trades without intermediaries. Other cryptographic technologies, such as zero-knowledge proofs, can be used to verify the integrity of dark pool transactions.

Dark pools can also be useful in illiquid cryptocurrency markets, allowing traders to execute larger trades without slippage. In illiquid markets, a sizable order can have a significant impact, but the same trade can be executed in a dark pool without affecting the market price.

Currently, the impact of dark pools on the cryptocurrency market is minor due to the lack of institutional traders. However, with the potential for increased institutional adoption in the future, the impact of dark pools in the cryptocurrency space may grow.

Conclusion

Dark pools have been a controversial topic due to their lack of transparency, which conceals a significant portion of the trading volume. However, recent advancements in cryptographic verification methods could make using dark pools safer. By using open-source protocols, it is possible to build systems that maintain the same rules for all participants, which reduces the risk associated with using a dark pool.