The Risk and Reward of More Dark Pool Trading

Dark pools, more loosely regulated trading venues in the United States, are becoming increasingly popular. Advocates for these trading venues claim they boost market liquidity while lowering risk, while critics claim their lack of transparency leaves them open to predatory practices. Despite their controversy, dark pools have taken the U.S. by storm, capturing over 40% of average daily market share and reaching as high as 50% on some days in the U.S., while in countries like Canada, they amount for only 7% largely due to a higher standard of regulation. Nasdaq Canada’s CEO, Dan Kessous, and Rosenblatt Securities Partner, Justin Schack, weighed in on the stark differences in market participation and the use of dark pools in U.S. and Canada. In a recent TradeTalks segment, they discussed how dark pools operate, the benefits and concerns of these venues on the market, and how governments will regulate them in the future.

The Primary Reason for Using Dark Pools

When institutional investors need to trade large swaths of shares, these orders tend to have a large impact on the market. For example, if a company is selling 1 million shares of a security, trading these shares on a public exchange may result in a large decrease in the stock price, creating greater volatility in the market and an inferior execution price for the investor.

The problem of price volatility that can result from trading large institutional sized orders was accentuated when trading became electronic. Faster trading means faster changes in the market. Today, market price changes happen in milliseconds.

However, if a company can find buyers, sell its bulk stock privately, and later disclose these sales to the public, market prices will see less price impact ultimately reducing risk and resulting in the investor selling at a higher price.  

According to Schack, “You have a very large order that can sometimes move the market. Going into the dark marketplace can minimize that footprint, keep you anonymous and result in better execution quality. Then the market makers on the other side of those retail orders are taking less risk. It's less risky for them than it would be to put a quote on an exchange marketplace. So, a lot of times you can get a better outcome, and that's why we see a lot of different types of market participants using these dark marketplaces.”

The Pros and Cons

Many proponents of dark pools including buy-side institutions such as mutual funds and pension funds advocate for the cost advantages of these trading venue’s – by facilitating better execution prices retirement accounts can continue to accrue value, which is then directly translated to the retail investor with a 401k, pension, or other retirement account.

But dark pools are not universally supported by all market participants. Critics complain that their lack of transparency is worrying and that this is made worse by the fact that they are increasingly not being used for their original purpose—minimizing market impact when trading large orders. Celent, a firm that advises on financial technology, found that from 2009 to 2013, the average execution size traded on dark pools in the United States dropped by more than half, from 430 to 200.

“There's this huge conversation now about, is there too much dark trading? Are there conflicts of interest involved in some of the ways that retail orders are executed? And I think the SEC has said it's working on rules that they expect to propose by April. That can make pretty big changes to a lot of those things. So, who knows?” said Schack.

Outlook for Dark Pools

While U.S. investors wait patiently for possible SEC regulation and whether the SEC will revisit its view on allowing exchanges to operate dark pools, in Canada, Kessous hopes to increase dark pool use in the coming years. Nasdaq Canada’s CXD Trading Book, a dark pool created in Canada and launched in 2016, is now one of the highest performing dark pools in the market.

“The two dark pools that get the bulk of the share are CXD and MatchNow. The other three really get about less than half a percent of the market share together,” according to Kessous.

By making retail orders free and incentivizing market makers to provide liquidity at price-improve levels, Nasdaq Canada’s CXD has incentivized trading and increased its market share.

These innovations have led to accelerating results.

“We reached a milestone of 1% a couple of years ago and have been growing since then. We are now capturing about 1.6% daily and we’ve seen several days at around 2%,” said Kessous.

Kessous thinks more dark trading on the Canadian exchange will lead to a greater return for investors.

Conditional orders are another innovation of dark pools growing in the markets. These orders allow traders to shop around for liquidity on multiple venues, entering orders that are willing to trade on the condition that a matching counterparty is found. This creates a potential for more trades and increases liquidity in the market leading to an overall increase in trading done.

“We've seen [conditional orders] grow in the U.S., and it has been well received and adopted by a lot of participants. It's grown the market share and we've seen it in Europe as well. Now, we're seeing it in Canada; there are a few dark pools that are introducing conditionals on their books,” said Kessous.

Going forward, Kessous is tracking the efficacy and efficiency of dark pools with the hope of providing more insight into their market impact. “We haven't been resting on our laurels. We're looking at a model that will help source block liquidity and minimize market impact. We'll have that sometime next year,” said Kessous.

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Dan Kessous

Nasdaq

Dan Kessous is Chief Executive Officer at Nasdaq Canada. In this role, Dan is responsible for the Exchange’s strategy and oversight of its business and operational functions. Dan joined Nasdaq in 2016 through the acquisition of Chi-X Canada ATS Limited where he was CEO. 

Read Dan's Bio