“Dark Pools”: Worse Than High-Frequency Trading?

Posted

stock market dark poolOn top of recently revealed concerns that high-speed traders have been tampering with the U.S. stock market, there’s another factor that is stacking the odds against investors—and could be costing them millions a year.

Trading takes place on several different platforms: Brokerages can buy and sell orders from its own customers (known as internalizing), trade on exchanges or send trades to “dark pools”—which operate like exchanges except their fees are lower and they are anonymous.

Trading on exchanges is by far the most transparent option, but that type of trading is declining rapidly. When a trade doesn’t make it to an exchange, it benefits the broker but is harmful to the market as a whole: The broker avoids fees, but since so much trading is happening away from public exchanges, publicly quoted prices for stocks on exchanges may not actually reflect market conditions. With trillions of dollars worth of stocks being traded in a given year, even small misrepresentations of prices can equal tens of billions of dollars.

According to Yahoo Finance, 40% of U.S. stock trades, including essentially all trades from Average Joe investors, are now happening outside of exchanges. There are 45 dark pools and 200 internalizers, but only 13 public exchanges.

Dark pools were originally created for large institutions to trade large amounts of stock without making waves in the market: If an order of a million shares was reported on an exchange, the price of the stock could get jacked up, costing the company more at the last second.

But that kind of trading doesn’t really exist anymore. The average size of dark pool orders is about 200 shares, which is on par with orders on exchanges. Other countries, like Canada and Australia, have begun to regulate dark-pool trading to preserve market quality.