10 Things People Don't Get About Dark Pools: Ross
To most people "Dark Pools" are a mystery. Heck, most people don't even know what they are. In a nutshell it's Wall Street slang for private stock trading platforms operated mostly by brokerages.
Dark Pools are electronic Alternative Trading Systems, very similar to stock exchanges where trades can be matched. The big difference of course is that the orders are dark, meaning that the size and price of the orders are not revealed to other participants. This limits the amount of interaction because the participants don't know when to move their price up or down to find the contra side of their trade or when the contra side may be present in the pool. These pools are mostly used by sophisticated professional traders.
Nevertheless, there is a lot of criticism about them lately. Odd, since in many cases the critics are not the users. In fact, the actual users of dark pools seem to be happy because they keep sending them more and more volume; clearly they are having a satisfactory experience.
(Read More: Dark Pools: Letting Some Light in Now?)
With so much uncertainty, I think it's time to set the record straight and deal with the significant amount of misunderstanding about how they operate. So in David Letterman fashion I have created a list:
"Top Ten things people don't understand about Dark Pools"
1) It is not a "Black Market," it's just not displayed. Many comments in the media imply that Dark Pools are the "wild wild west" and anything goes; every man and woman for themselves, customers are exploited, brokers make tons of money. This is not the case.
2) Dark Pools have been around since trading began; it's not new, it was just called "upstairs trading" in the past.
3) The Securities and Exchange Commission has recognized the importance for institutions to be able to work orders without displaying the whole order "to maintain long term confidence" in the markets. Cited multiple times in regulatory comments, particularly those around Reg. NMS - the new rules governing the National Market System.
4) Dark Pools are highly regulated. All Dark Pools are broker-dealers registered with the SEC and The Financial Industry Regulatory Authority (FINRA) and subject to regular audits and examinations, similar to an exchange.
5) Users "opt-in" to placing their orders in a Dark Pool. The users are intelligent traders who understand the advantages of not displaying their orders at an exchange.
6) Dark Pool trades are bound by the "NBBO" or National Best Bid and Offer. Prices cannot be chosen arbitrarily, many times the price is actually the midpoint of the NBBO but a stock cannot trade outside the NBBO without an inter-market sweep satisfying orders on other markets.
7) More volume is trading in the Dark Pools because it works for institutions. The percentage of non-exchange trades has grown to roughly 33 percent of all trades up from 8-10 percent a decade ago; this is because the users of Dark Pools have had a better experience in the dark than at an exchange.
(Read More: Man Vs. Machine: The New Kings Of Wall Street)
8) Different Dark Pools have different features to appeal to different segments of the market. Some only allow certain types of traders, say "Buy Side to Buy Side" so naturals can trade with each other. Other Dark Pools allow you to rank your contra trading partners and opt out of those you don't want to trade with. This allows the traders to create a customized experience different than the exchange one size fits all approach.
9) Orders in dark pools are like ice bergs. For a trade to take place, a resting bid, or buyer, has to be present when a seller initiates a sale. Many times both sides are not present at the same moment as orders are cancelled and replaced, these orders are referred to as "ships passing in the night".
10) The biggest reason people are afraid of "Dark Pools" is the name, like a kid being stuck in a closet by a mean sibling, the image is frightening. Maybe they should be called "Block Trading Venue for Institutional Traders Who Know What They are Doing". BTVITWKWTD -Doesn't exactly roll off the tongue does it?
Now trying to understand how Dark Pools interact with high frequency trading is a whole other conversation. One that needs more than a top 10 list, and I think better for another time.
(Watch: For a good look at all the questions and concerns surrounding dark pools, check Wall Street Journal reporter Scott Patterson's CNBC interview about his book called "Dark Pools.")
D. Keith Ross is the Chief Executive Officer of PDQ Enterprises, owner of PDQ ATS, a new equity trading venue that emulates the interaction and dynamism of traditional floor brokers in a high-speed, electronic trading environment, where algorithms compete to fill orders. Prior to PDQ, Keith was the Chief Executive Officer at GETCO and began his career as an options analyst in 1976.