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Private exchanges that are not accessible by the investing public for trading securities are known as dark pools.
Dark pools are named due to their lack of transparency and occasional predatory trading practices that are performed by high-frequency traders.
These exchanges originally into existence towards the end of the 1980s as a way to better facilitate block trading performed by institutional investors.
Why Use Dark Pools?
Dark pools are used primarily by large-scale investors who do not seek to sway markets through enormous trading positions or incur adverse prices due to their large transactions.
Of note, dark pools don’t require investors to disclose their trading intentions prior to trade execution.
As such, there is no order book or ledger available to the public while performed trades are released after a delay in the ticker tape, also known as the system that reflects real-time exchange-listed data.
More than 48 dark pools have been registered with the Securities and Exchange Commission (SEC) while dark pools can be divided into three classifications.
Dark pools that derive their own price rates from order flow implement an element known as price discovery.
This is seen characteristic of dark pools that are broker-dealer owned and electronic market makers.
Electronic market makers, such as Getco, are independently operated dark pools who function as administrators for their own account.
Examples of broker-dealer owned dark pools include Goldman Sachs’ Sigma X, Morgan Stanley’s MS Pool, and Citibank’s CitiMatch.
Dark pools that are broker-dealer owned are structured to fulfill the needs of their clients and sometimes their own team of proprietary investors.
An exchange-owned or agency broker dark pool serve as agents, not administrators, while prices stem from exchanges such as the National Best Bid and Offer (NBBO).
An example of exchange-owned dark pools includes the NYSE Euronext while the Instinet Liquidnet is an example of an agency broker dark pool.
Despite the notoriety that surrounds dark pools, dark pools serve an essential function and can significantly reduce market sways by large scale trades.