Market Analysis

Binary Smoke, Encoded Scotch

So-called dark liquidity pools are changing how we trade stocks, and bringing us a step closer to more efficient markets.

There was a time when monocled men in suits made stock deals in dark rooms—sipping tumblers of Scotch and squinting through a haze of cigar smoke. Then along came a different, more televised Wall Street where trading shares of public corporations was captained by bedraggled traders pacing the paper-strewn floor of the New York Stock Exchange.

Now times are changing again—stock trading's headed back into the dark. But for cigar smoke, substitute anonymous electronic networks; and in place of monocles and Scotch, think complex search algorithms probing the ether for matching orders across the world. A "dark pool" is an online market increasingly used by hedge funds and big brokerages to execute trades electronically, without middlemen and safely out of the public eye.

Why are hedge funds and big brokerages so eager to use dark pools? They help institutional traders avoid a trade's "impact cost." Traders incur the impact cost when speculators artificially inflate prices by buying stock just prior to a publicly announced institutional block trade (a huge aggregate trade made up of thousands or even millions of shares and capable of moving markets on execution).

Dark pools can also help traders avoid another component of impact cost: If a trader can't find a buyer for their whole block (which is often the case), the price of a large order must be incrementally stepped up and executed piece-meal. This increases both transaction costs and average price.

But what does this mean for the average investor?

If you're like me, you probably picture your stock orders forwarded to a panic-stricken trader (with disheveled hair, loosened tie and untucked shirt) leaving the phone dangling on its cord and shouting at the top of his lungs, "Mr. Smith wants seven shares of XYZ! That's seven, count ‘em, seven. I heard ol' Goldie's comin' home on seven and if soil meets sod, we'll have a deal! C'mon what's the price on XYZ? $34 you say?? Why you lousy sonuva…OK fine, done—buy, buy at $34!!"

Sitting in an account's transaction log, it seems your trade received personal attention, but if you own a mutual fund or work with a registered investment adviser, it's likely the order was part of an institutional block trade. You get the best average price an institutional trader can finagle—but that price has been inflated by its impact cost. Enter dark pool liquidity. Minus the public eye, your trading costs could decrease—potentially by a lot.

But dark pool liquidity has its critics. Some complain dark pools have splintered trading, making it more difficult to find a trade match. It's undoubtedly a technical challenge finding liquidity over the spectrum of 42 dark pools existing today—up from just seven dark pools five years ago. Also, not everyone broadcasts on dark channels. You might find a business partner in a dark pool, or you might still need to go public.

Currently, mathematicians cooperating with slick programmers are tackling some of these problems. Well-known firms like Citi and Credit Suisse, or niche industry veterans like Instinet, are inventing and marketing search programs (sometimes called dark-pool aggregators) with super-secret spy names like Guerilla, Sniper, and Nighthawk. These search mechanisms break huge trades into manageable pieces and also find suitable matches over many networks at once. Further, many expect the large number of independent pools to begin merging in the near future, and like all market-driven innovations, as competition intensifies, dark pools will evolve to survive.

Whatever the future of trading in the dark, technology is taking us closer to greater market efficiency. And the more markets are freed from systemic sticking points the better for investors.

For more on dark pools, check the below links:

Growing Dark Pool Trading Volume Could Be Problematic for Exchanges

Boom in ‘Dark Pool' Trading Networks Is Causing Headaches on Wall Street

‘Dark Pools' Are Tempting Morsels for Major Stock Exchanges

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.