Dark Pools Explained: The Secrets of Invisible Trading

Ten percent of shares are traded in a dark pool. For this reason, SIX introduced SwissAtMid eight years ago in Switzerland. Spain has now followed with SpainAtMid, mirroring the Swiss setup, while other European exchanges like Euronext and Deutsche Börse also joined recently with their respective offerings for non-displayed trading. But what exactly are dark pools, and how dark are these trades? Let’s discover the functionalities and the benefits that these trading platforms offer.

A dark pool is a specialized trading platform where orders are entered anonymously. Eligible participants are exclusively banks and institutional investors. These institutional investors, such as large trading companies, operate at a significant scale. Unlike public order books, dark pools do not disclose information about trading activities or participant identities prior to a transaction – that’s why they are also called “non-displayed” pools. Information is provided only once a trade has taken place.

The trade is executed at the mid-point between the bid and ask prices (the bid-ask spread). For instance, if a buyer is willing to pay 43 Swiss francs for a stock and the seller wants 45 Swiss francs, the trade is settled at the mid-point price of 44 Swiss francs.

The history of dark pools began in the early 1990s in the United States. Initially, the demand came primarily from stock sellers who had to conduct large trades “over-the-counter”. The first official dark pools appeared in the early 2000s in the US. 

In principle, any bank or broker can get access to a dark pool - provided they are registered as a trading participant of the operator. Prior to admission, participants must test their systems to ensure that they meet the technical and operational requirements.

In a lit order book, where all buy and sell orders are visible, selling 200 shares of Nestlé without affecting the price is simple. But selling 2 million shares brings its challenges. When it becomes known that a large pension fund or another significant investor is offloading millions of shares, institutional buyers often retreat, anticipating a price drop. So, the seller may lose money by selling at a gradually lower price.

The main advantage of dark pools is therefore that the orders initially remain hidden and enable large transactions without negative market influences. In contrast to a lit order book, dark pools eliminate the risk of other market participants trading aggressively against the seller and depressing the price further - or, conversely, trading against the buyer and driving up the price.

In the past, institutional investors needed to collaborate closely with brokers to develop efficient methods for trading large volumes while avoiding clear signals about their trading intentions.

Before computer-driven dark pools, traders often withheld bids and offers to conceal their intentions. This approach worked thanks to “not-held orders”, where sensitive orders were confidentially passed to brokers. Brokers executed the trade without making it public while searching for a counterparty. However, this process often resembled a cat-and-mouse game and required significant trust in the counterparty, who could manipulate the process for better pricing.

Dark pools automate this process on the basis of a clearly defined set of rules. Traders place orders “in the hands” of computers. Like brokers of the past, the computer does not disclose information about orders in the pool. If a matching order is also placed in the pool, the computer compares the two, and the trade is executed. 

Trades are executed at the mid-point price. On the exchanges operated by SIX in Switzerland and Spain, the matching logic is based on trade-size/time priority. This ensures that large orders are matched with corresponding demand in the pool, regardless from the time of order entry, while minimizing parallel execution of smaller trades. Both buyers and sellers benefit from identical conditions. Official dark pools also help to ensure that participants comply with regulatory requirements - to protect end investors.

As dark pools have grown in significance, regulatory requirements have also increased. Initially, dark pools operated with little oversight, raising concerns about market manipulation and unfair trading practices. Regulations the Markets in Financial Instruments Directive I and II (MiFID I and MiFID II) have been introduced to enhance the safety, transparency, and resilience of these trading practices.

Regulators and supervisory authorities worldwide, including SIX Exchange Regulation (SER) in Switzerland and CNMV in Spain, have implemented measures in recent years to improve the transparency of these platforms.

These regulations are crucial for building trust in dark pools and preventing misuse. For instance, dark pools are now required to provide detailed reports on their trading activities and ensure their platforms are not used for market manipulation. These measures have bolstered confidence in dark pools, establishing them as legitimate trading venues.

Dark pools now account for nearly 10% of pan-European trades. This trend underscores the growing interest and acceptance among traders. The launch of new dark pools at various European exchanges further highlights this demand and could further increase the volume.

Simon Quoid-Mason, Head Equity Product & Quant Research at SIX, predicts that new algorithms and AI-driven systems will continue to enhance the efficiency and appeal of dark pools while maintaining transparency and fairness in trading.