What is a dark pool and how is it different to traditional stock exchange ‘lit’ order books?

Dark pools mitigate potential market impact by allowing orders to reside in an order book where the price and size of an order are not displayed until after the trade. Users of a dark book, therefore, have no certainty – pre-trade – that another order is in the dark pool. The benefit, however, is the ability to place orders without revealing one’s intention, pre-trade.

Dark pools and electronic block trading above Large in Scale (LIS) have become popular among fund managers who are keen to buy or sell large blocks of shares with minimal market impact at a justifiably fair price, while avoiding signalling risk that can alert other investors to their intentions and push the price against them.

Furthermore, an investor can peg the non-displayed price of the order in the dark pool to follow the mid-point of the bid and offer displayed on the reference lit Primary Exchange. After a dark pool trade, the price and size of the completed order is published. This is important as it adds to transparency for all investors, because post-trade transparency is pre-trade transparency for the next trade.

Consider the analogy of buying a house. The estate agent provides a ‘pre-trade’ price, but it also helps to know the actual price of the house recently sold next door, ‘post-trade,’ before making an offer.

Lit order books display price and size of bids and offers on screen so that orders are visible prior to execution. The benefit is certainty of trade. The challenge is potential market impact.

Dark pools complement lit order books as an extra knob on the dial that helps investors get business done. Dark pools match between five and ten per cent of all order book trading of UK and European shares.

Why were dark pools created, and what are the benefits?

Dark pools have evolved to facilitate trading of large orders by institutional investors who do not wish to impact the market with their activity. Dark pools play a significant role for large financial institutions, including pension funds, and therefore for private investors who ultimately own these funds.

Modern equity market trends include global passive indexation and the desire to outperform benchmarks by trading block liquidity, increasingly in mid and small caps, diversified by geography. Today, European real returns are near zero, so professionals focus increasingly on the efficiency of trading clearing and settlement at instant of investment to minimise slippage costs to enhance long-term investment returns.

The benefit of a dark pool is the ability to place orders – from small to very large – without revealing one’s intention, pre-trade.

Who runs dark pools?

Brokers and regulated markets. Investors that use dark pools can benefit from potential price improvement which means better investment performance. Like any tool, it is important to understand how it works to get the best result. 

How does a midpoint dark pool work?

On a traditional stock exchange, prices and order sizes are displayed prior to a trade. For example, Stock A might show a bid price of 98 for 5,000 shares and an offer of 4,000 shares at a price of 102. If we want to buy 1,000 shares, we can tell our broker to lift the offer and pay 102 per share for 1,000 shares. The insight is that we have to pay a higher price, 102, for immediacy to complete our order.

Dark pools are where dark orders reside. Dark orders, pre-trade, do not show their price and size to the market. After buy and sell orders match, however, the price and size of the trade is displayed. This method of trading is hardly novel. The traditional matching by brokers of buy and sell orders on the way to the market is an example of accessing ‘dark’ liquidity.

Consider this second example of a broker that receives an order to buy 1,000 shares from one customer (us) and a sale of 700 shares from another customer. One logical action is to match the buyer (us) and seller for 700 shares at a fair midpoint price halfway between 98 and 102, that is 100, and work the balance of our purchase of 300 shares in the market by lifting the offer and paying 102.

Just before the broker matches these 700 shares, that broker is a human ‘dark pool’ because the price of 100 and size of 700 shares are not displayed to the market before the trade.

After the trade, a public print shows a trade of 700 shares at a price of 100.

In the first example, we pay 102 per share for 1,000 shares, which equals 102,000. In the second example, we pay 100 per share for 700 shares, which equals 70,000, plus 102 per share for 300 shares, which equals 30,600 – leading to a total of 100,600. The effective price in the second example is 100,600 divided by 1,000 shares, which equals a 100.6 average price paid.

In the second example, we achieve price improvement since we have purchased our 1,000 shares at only 100.6 instead of 102. We benefit in the second example because we achieved the opportunity to meet a seller of 700 shares at the midpoint price.

In more recent years, this process of brokers matching of buyers and sellers in the ‘dark’ on the way to the ‘lit’ market has become automated via algorithms.

How is regulation, and in particular MiFID II, affecting dark pools?

The first Markets in Financial Instruments Directive (MiFID), effective from November 2007, encouraged use of alternate venues, including dark pools, as competition for order execution. MiFID abolished the ‘concentration rule’, which previously constrained competition and innovation by forcing investors to trade only on a country’s primary stock exchange for instruments listed on that stock exchange.

With the earlier introduction of the euro in 1999, many trading desks had already switched from being country-specific desks to specialising in trading stocks in specific sectors across different countries. Most trading infrastructure had relocated to London, strengthening its position as a hub and leading international financial centre for innovation, choice and efficiency. This included London as a data centre location, hosting matching engines for multiple primary stock exchanges, including those of Belgium, France, Netherlands, Portugal, and Norway.

Dr Robert Barnes, Chartered FCSI

Dr Robert Barnes is global head of primary markets at London Stock Exchange Group (LSEG) and CEO of Turquoise, the European multilateral trading facility majority-owned by LSEG in partnership with the user community. Prior to joining Turquoise LSEG in 2013, Robert worked at UBS for more than 19 years, including as managing director equities, and founding CEO of UBS MTF, which grew to become the leading dark pool in EMEA, before he moved to LSEG and Turquoise. His roles include serving as chairman of the Securities Trading Committee of the London Investment Banking Association between 2004 and 2009. Robert holds a BA from Harvard, a PhD from Cambridge, and is a Chartered Fellow of the CISI. After the introduction of MiFID, new pan European trading venues offered trading in securities of multiple countries with one connection into London. This multilateral trading added significant efficiency to the investment process, further enhanced with innovations in trading mechanisms like midpoint matching, periodic random uncrossing, and electronic block trading. These innovations added additional execution channels for investors to get their business done and helped complement those traditional execution channels including closing auctions provided by a country’s primary stock exchange.

A natural feature of all order books worldwide, whether they are lit or dark from a pre-trade transparency perspective, is that average trade size tends to shrink. If there is a large order to buy that meets a small order to sell, then the resulting trade size is the smaller size.

For Europe, the stochastic impact since 1999 has been the shrinking of order book trade sizes to an average of approximately €10,000 per trade, in both lit and dark pools. The consequence is that for institutions with wholesale-sized orders of a larger multimillion scale, these smaller trade sizes lead to aggregate impact cost.

MiFID II, effective from January 2018, introduced the concept of double volume caps (DVCs), which the European Securities and Markets Authority (ESMA) implemented in March 2018. It states: “The purpose of the DVC mechanism is to limit the amount of trading under certain equity waivers to ensure the use of such waivers does not harm price formation for equity instruments. More specifically, the DVC limits the amount of dark trading under the reference price waiver and the negotiated transaction waiver.”

Covering a rolling 12-month period, the caps are calculated on a per symbol basis with reference to total EU on venue value traded of 4% on any particular single venue or 8% on an aggregate multiple venue perspective market-wide. Stock symbols that are above these calculated thresholds are ‘capped’ and prevented from trading in reference price waiver systems (dark pools) or via negotiated trade waiver. While many practitioners feel there is little substantive analysis justifying the implementation rationale of the DVCs, including their levels of 4% and 8%, the market, nevertheless, is fully complying with the rules.

Even in the presence of the DVCs, investors can continue to benefit from midpoint matching that can save implicit cost of half the bid offer spread: as long as an order received by a market operator in a respective symbol must be above the ESMA LIS size for that symbol. The smallest LIS threshold today is €15,000, and the LIS for larger blue chips is over €500,000. With the average trade size in Europe being €10,000 or less, small-sized trades will be blocked from most continuous dark pools during the requisite six-month period of exclusion for those symbols capped by the DVCs. So some pools will see a drop in activity, and some may close.