M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.
Alternative Trading Systems
Paul manages the pension fund for a large multinational corporation. He does his very best to get the greatest return on the millions of dollars he manages. After all, it represents the hard earned savings of thousands of workers. The decisions he makes will affect what kind of retirement they will have.
Paul has been reading a lot about self-driving and electric vehicles. He thinks they will be the way of the future and he wants to get ahead and invest some of the pension fund money in the industry.
Paul isn't going to make that investment the way that most of us would, using a broker to buy shares in a company through one of the major stock exchanges. He is going to use an alternative trading system.
Alternative trading systems perform the same matching of buy and sell orders that a major stock exchange does, but they are not regulated like a normal exchange. Let's join Paul as he visits one of these alternative trading systems.
Paul gets a cab and goes to one of the bank buildings in lower Manhattan. When he walks in, he heads for the elevator where he is whisked down five stories below ground level. He gets out and walks into a brightly lit trading room run by a firm called Below Ground Capital or BGC.
Below Ground is an alternative trading system that caters to institutional investors like Paul. It is known as a dark pool because buying and selling shares there can be done in secret and away from the scrutiny that happens when you trade on a major exchange.
All dark pools aren't located underground, but some people say they may as well be because of the secretive nature of their operations.
Trading in the Dark Pool
Paul is here today to take a large position in Crashproof, a small company that makes sensors for self-driving vehicles. Paul knows that as soon as his order would appear in the order books at a major exchange, the word would spread like wild fire and soon other investors would want to get their buy orders in before Paul's could be executed, a practice known as frontrunning.
That would drive up the share price of Crashproof and Paul would have to pay more to get his shares. That wouldn't be in the best interests of all of those workers Paul is investing for.
Here in the dark pool, Paul can make a bid for 100,000 shares of that company and no one will know outside of the other traders and investors at BGC. Fifteen minutes later he is happy to see that another BGC member is agreeable to selling his shares to Paul. They make the transaction and Paul is thrilled to get this investment done for the workers in the pension fund!
Benefits of Dark Pool Trades
By making his trade at Below Ground, Paul was able to get a better price on his trade. Even if that is only a dollar or two, it adds up to serious dollars for an individual or institutional trader buying and selling thousands of shares.
BGC also offers lower transaction fees than the major exchanges, so Paul gets two wins for the pension fund by trading there.
The Regulatory Environment
Up until recently, the Securities and Exchange Commission regulated the dark pools under rules written in 1998. Since then, advances in technology have made the old regulations obsolete. Shady dark pool operators were using their own traders to trade against the interests of their clients like Paul. High frequency trading operations using advanced technology were getting access to the dark pools order books, and frontrunning dark pool trades to make large profits.
Regulations clearly needed to catch up with the times. Dark pools are now required to register with the Securities and Exchange Commission, and to date over 40 have done so. New regulations enacted in November of 2016 are aimed at greater transparency about pool operations and who has access to trading data.
Summaries of trades are issued weekly that show what dark pool traders are buying and selling. The objective is to bring dark pools at least a little more into the light of day without losing their advantage to institutional traders.
Alternative trading systems perform the same matching of buy and sell orders that a major stock exchange does, but they are not regulated like a normal exchange. Dark pools are alternative trading systems that allow institutional investors to buy and sell large quantities of stock in secrecy, away from the transparency of trading on a major exchange.
This is advantageous because public stock exchanges are transparent, and large buy and sell orders can give other investors incentive to frontrun the large order. In other words, to buy before the large order is executed, which would drive up the share price.
Letting alternative systems operate in the dark led to abuses as technology made new types of trading possible. New regulations by the Securities and Exchange Commission have the objective of bringing the dark pools more into the light of day without losing their advantage to institutional traders. Dark pools are now required to register with the Securities and Exchange Commission, and to date over 40 have done so.
To unlock this lesson you must be a Study.com Member.
Create your account
Register to view this lesson
Unlock Your Education
See for yourself why 30 million people use Study.com
Become a Study.com member and start learning now.Become a Member
Already a member? Log InBack
Resources created by teachers for teachers
I would definitely recommend Study.com to my colleagues. It’s like a teacher waved a magic wand and did the work for me. I feel like it’s a lifeline.