A Simple Introduction to Dark Pools

What is a dark pool?

A dark pool is a private venue facilitating the exchange of financial instruments. It differs from a public exchange in that there is no visible order book, and trades are not publicly visible (or only become visible once they already have been executed).

Liquidity on dark pool markets is called dark pool liquidity. A majority of dark pool trading is done in block trades. A block trade is a transaction of a large quantity of an asset at a predetermined price.

Dark pools first emerged in the 1980s and have mostly been used by institutional investors who trade large numbers of securities.

Using dark pools allows institutions to place orders and make trades without publicly revealing their intentions first. This is a useful trait, as their intentions to buy or sell large amounts of an asset could have a detrimental effect on their trade before they have a chance to execute it.

Dark pools have grown to be a sizable part of the global equity markets, and this article will examine their potential impact on the cryptocurrency space.

What are the advantages of using a dark pool?

·       Decreased impact on market sentiment – Traders wishing to trade large size can conceal their intentions from the wider investing public. 

·       Price improvement – The matching of trades is often done based on the average of the best available bid and ask price. In such cases, both the buyer and the seller get a more favorable trade than they could on the open market (the buyer gets to buy lower, and the seller gets to sell higher). 

·       No slippage – Since most of dark pool trading is done in block trades at predetermined prices, traders can be sure that they will be able to execute their entire trade at the intended price.

What are the controversies around dark pools?

·       Conflict of interest – Since the order book is not visible, there is no guarantee that a trade was executed at the best possible price. If the institution facilitating the trade has a conflict of interest, it has the ability to obscure real market prices.

·       Detrimental effect on market prices – If the majority of trading happens in dark pools, the prices on public exchanges may not reflect the actual market. A large part of investing and trading relies on the free flow of information, and dark pools hinder this availability.

·       Vulnerability to high-frequency traders (HFTs) – Dark pools can be an ideal playing field for predatory practices by high-frequency traders. If they have privileged access to order book data, they can front-run large orders and take advantage of unsuspecting traders.
Dark pools also enable another method called pinging, which includes sending a large number of small orders to map out a large hidden order. It is used to gauge areas of liquidity in the order book and gives high-frequency traders an advantage that can be considered unhealthy for the market.

·       Smaller average trade size – Since their emergence in the 1980s, the average trade size of dark pools has significantly decreased. This signals that not only financial institutions who trade large size are using dark pools anymore. This makes their existence much less compelling and possibly even detrimental to the broader market. It may lead to a healthier market if smaller orders are executed in exchanges with a publicly visible order book.  

Decentralized dark pools

Similar to dark pools in the traditional equity markets, dark pools for trading cryptocurrencies are available in some trading platforms.

Compared to regular dark pools, decentralized dark pools can have the advantage of more secure digital verification methods. Decentralized dark pool protocols could maintain a fair market price for all participants without the possibility of price manipulation. 

In trades involving multiple blockchains, cross-chain atomic swaps could be used to facilitate the trades without the need for an intermediary.

Decentralized dark pools could also employ other novel cryptographic technologies such as zero-knowledge proofs to verify the integrity of dark pool transactions. 

Dark pools can also be useful in illiquid cryptocurrency markets, as they allow traders to execute larger trades with no slippage. While a sizable order could have a considerable impact on an illiquid market, the same trade can be executed in a dark pool without slippage.

Due to the lack of institutional traders in the cryptocurrency space, dark pools have had a minor effect on cryptocurrency markets, but that might change in the future.

Closing thoughts

Due to the complete lack of transparency, dark pools have been a topic of controversy since their existence. Concealing a majority of the trading volume is not a desirable property when it comes to any market.

With the recent developments in cryptographic verification methods, the process of using dark pools could become safer. Open-source protocols can be built in a way that verifiably maintains the same rules for every participant, which reduces the risk of using a dark pool.