Taking the Plunge

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Dark pools labor under a sinister sobriquet. To the uninitiated, they sound like part of the title of a novel by J. K. Rowling. Their advocates prefer more anodyne terms: non-displayed or private markets and off-exchange or “upstairs” trading.

Whatever their name, however, investors are jumping in. In 2008, dark pools represented approximately 6.55% of the US equity market’s total trading volume. By the end of 2012, this figure had more than doubled. For some of the highest capitalized and most liquid securities, almost half of their trading volume happens “upstairs.” And as these venues proliferate, the question arises for asset owners: do they really understand how much these waters have changed?

Dark pools offer one enormous attraction for institutional investors—discretion. By sending trades through private exchanges, investors can execute large orders at a fixed price. In the simplest terms, a pension fund can use a dark pool to sell a big equity position without sending the price of those shares down as they carry out the trade, and vice versa. Before the advent of dark pools, institutional investors had to hide sizeable orders by breaking them into smaller parcels. This process was time-consuming and risky, for in the meantime the market could move against their position (especially if word of their strategy leaked). Dark pools allow investors to avoid this hazard.

Yet they also carry with them their own risks. Historically, two main drawbacks have accompanied off-exchange trading: illiquidity penalties and information leakage. When a fund cannot immediately find a buyer for its shares, the market will usually move against it. The explanation is self-evident: if an investor’s sell order cannot be filled, that suggests that the sellers outnumber the buyers, and so a downward price swing is imminent. As a result, only highly liquid shares are suitable for dark pools. Information leakage, also known as toxicity, represents a more nefarious risk. Investors need to trust that dark pool operators will not preempt their orders to make a little money—or sell the information to someone else that will. That said, these risks are known and manageable.

Under the surface, however, dark pools—and their dangers—have been evolving. Between the 1980s and 2007, the main exchanges operated them on the side, and they largely remained the exclusive reserve of institutional investors. In 2005, these dark pools made up approximately 3% to 5% of trading volume. The deluge began in 2007. A Securities and Exchange Commission (SEC) rule change, the Regulation National Market System—designed to improve inter-exchange price sharing—opened the floodgates on dark pools. They have sprung up by the dozens at broker-dealers, which can facilitate trades between their own clients internally.

Unlike the dark pools of yore, broker-dealers regard these new venues as revenue-generators, and have begun inviting opportunistic traders to take a dip. From sleepy exchanges where pension funds swapped shares away from the ticker, dark pools have become filled with high frequency and algorithmic players hunting for arbitrage opportunities.

This new landscape has both retained the old risks and added new ones. Illiquidity penalties persist, as does information leakage (witness the SEC slapping dark pool operator eBX with a fine in October 2012 for sharing clients’ confidential trading information with an outside firm). But the greatest threats come from the rising abundance and primacy of dark pools. One menace is existential: What happens if dark pools eclipse traditional exchanges? Scribbling academics have raised this warning that prices on open markets may (soon or even already) no longer reflect true market conditions if trading continues to pour into dark pools. Regulatory intervention, perhaps to forestall this problem, adds more uncertainty into the mix.

For asset owners, however, the more pressing concern involves the profusion of choice. Like Priapus before them, institutional investors are learning that too much of a good thing is less than ideal. Finding liquidity has become troublesome because of the many dozens of venues available. Given their innate opacity, it is difficult to peer into dark pools to determine whether there are suitable trading partners. To exacerbate the problem, analysts expect the number of dark pools to multiply in the years ahead as Europe and Asia catch up to the United States.

So how do asset owners deal with this issue? Unfortunately, no panacea presents itself. Indications of interest—notifications issued by dark pools that offer limited information about unfilled orders—look promising, but they invite regulatory scrutiny and, through their public nature, could undermine the point of using a dark pool. At this stage, vigilance represents the best solution. Funds need to constantly monitor activity in the sundry dark pools. Only by keeping their toes in the water at all times can institutional investors avoid missing out on liquidity. Access, then, is key.

Despite this curse of plenty, the discretion and liquidity provided by dark pools continue to make them indispensible for asset owners. The simple reality is that institutional investors cannot afford to swim elsewhere.