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Dark pools

Dark pools: In the spotlight again  

Dark Pools are generally regarded as sources or pools of liquidity available for trading outside the transparency and scrutiny of organized exchanges. Dark pools operate without pre-trade transparency. They exclude publication of current bid and offer prices and the depth of trading interest at these prices, although it is important to note that post-trade prices and volumes are reported transparently.

Such pools of liquidity exist on:

  • organized multilateral trading platforms (i.e. regulated markets and multilateral trading facilities as defined by MiFID) which bring together multiple third-party buying and selling interests in financial instruments
  • internal electronic matching systems operated by a broker (broker crossing networks) that execute/cross client orders against other client orders or house account orders.

Key players include some of the major regulated banks, such as Credit Suisse (with its CrossFinder platform), Goldman  Sachs (Sigma X) and Deutsche Bank (Super X) but may also include specialist operators  such as Getco (GETMatched) and Knight Capital (Knight link).

Benefits and risks

Dark pools offer significant benefits to certain institutional investors (and hence indirectly  to their pension and retail clients) because they allow large blocks of securities to be traded without causing adverse market price movements in advance or revealing the institution’s position. large blocks of securities can often also be traded at a slightly lower cost.

An ever-increasing volume of trading in equities occurs in dark markets. Today onethird of all equity trading takes place off-exchange and over 1,200 securities have more than 50% of their volume traded off-exchange, an increase of 143% in less than two years."4

As a minor component of a dynamic market structure, the impact of dark pools can be minimal. However, in recent years, they have taken an increasingly large share of trading activity. Estimates vary, but Thomson Reuters suggests that dark pools accounted for 8.3 percent of the total in Q3 2012. Rosenblatt Securities, which publishes a monthly report on dark pool volumes and trends called Let There Be Light estimates that dark pools have  a market share of 14 percent in the US and  6 percent in Europe. In the case of many large multinational companies, the proportion of their shares which are traded in dark pools can be much higher; these companies make up  a significant fraction of total market value and represent major holdings by pension funds and investment managers who use dark pools to place large trades in their shares.

Although the term ‘dark pools’ has slightly sinister connotations, they are not inherently malign creations. In many ways, they are simply a natural evolution from over-the-counter (OTC) trading. Indeed, the growth of dark pools was stimulated by the fragmentation of financial markets and the abolition of concentration rules. These were undertaken in the interest of promoting competition and transparency and creating level playing fields. However, the scale of trading now occurring away from organized markets risks effecting market integrity.

Regulatory concern and response

Regulators have for many years advanced the principle that “Market transparency… is generally regarded as central to both the fairness and efficiency of a market, and in particular to its liquidity and quality of price formation.”1 The International Organization of Securities Commissions (IOSCO) has identified2 three major areas of concern in the development of dark pools:

Price discovery
The current market price for a security is derived from supply and demand and  information about transactions which have taken place. The greater the scale of supply and demand information, the more accurate the market price is likely to be. Dark pools can inhibit price discovery if orders that otherwise might have been publicly displayed are  hidden. If enough orders are not transparent to participants, or there is unequal or incomplete information about transparent orders, there may be insufficient information about prices for market participants to identify trading opportunities. Because dark orders and  dark pools do not contribute to pre-trade price discovery, there may also be concerns about whether they free-ride on the revealed intentions of other participants in the market.

Potential fragmentation of information and liquidity
A second issue is the potential fragmentation of information and liquidity between different market platforms, although as we have seen, fragmentation was, in  many respects, a response to deregulation. Nevertheless, dark pools make it more difficult for market participants to identify desirable trading opportunities. Multiple dark pools may pose specific information fragmentation problems due to their lack of pre-trade transparency and the possibility that post-trade information may not, in some jurisdictions, be consolidated with post-trade information from other venues.

Fairness and market integrity
One of the core objectives of securities regulation is to ensure that markets are fair, efficient and transparent. Dark pools may compromise these objectives if access is restricted to certain classes of participants. This concern is exacerbated where a dark pool has a significant market share and participants cannot access the liquidity within it. In a fair market, all similarly situated market participants should have equitable access to trading information on a reasonable and non- discriminatory basis. Regulatory concerns arise when access to information regarding liquidity in dark pools is restricted to a subset of market participants. This can jeopardize the level playing field and create a two-tiered market.

Regulatory response
Regulators in many jurisdictions are now seeking to exert more control over dark pools and, either through encouragement or explicit rules, are trying to introduce more transparency. For example, in Canada earlier in 2012, the Investment Industry Regulatory Organization of Canada (IIROC) published new rules applying to dark liquidity on Canadian equity marketplaces which specify what regulators may do to limit the impact of dark pools and dark orders.3 In Europe, where regulatory action is furthest advanced, these developments focus on the revision of MiFID (MiFID II/MiFIR), expected to be in force by 2014, which will seek to ensure that all organized trading is conducted on regulated and transparent trading venues.

Trust and confidence

Confidence in the fair and efficient functioning of financial markets has been severely damaged by the financial crisis. Trust in  such fundamental principles as fair prices, free access and a level playing field has been badly hit. The value of fair markets and fair prices goes beyond individual trades  and participants: the notion of a fair market price is fundamental to economic activity and underpins the creation of growth and prosperity.

The pressure is mounting on dark pools to prove they do not inhibit the process of efficient price discovery and create two classes of active market participants: those with access to their liquidity and those without. In turn, this relegates the retail investor still further down the hierarchy of information and participation. In this context, regulatory intervention the resultant justified and essential to try and prevent the resultant further damage to market credibility.

Dark pools will not be – and in practice  could not be – regulated out of existence. But they present a real threat when the volumes traded through them become a significant proportion of total market activity. So all market participants using dark pools need to be prepared for their activities to be significantly more constrained in the future. Institutional investors, asset managers, insurers, investment banks and others will all need to look to streamlining processes, improving transparency and reporting greater amounts of  information more rapidly in future.


  • Stephen Ball, Partner, KPMG in the U.K
  • Rob Voster, Senior Manager, KPMG in the Netherlands


  1. IOSCO, Transparency and Market Fragmentation, November 2001.
  2. IOSCO, Issues Raised by Dark liquidity, October 2010
  3. IIROC Notice 12-0130 – Rules Notice – Notice of Approval – UMIR – Provisions Respecting Dark liquidity
  4. Duncan Niederauer, Chief Executive of NYSE Euronext, Testimony to US HFSC Subcommittee on Capital Markets and Government Sponsored Enterprises, 20 June 2012
  5. MIFID Explanatory Memorandum, Brussels, 20.10.2011, COM(2011) 656 final

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