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Dark Pool Trading: Definition & Regulations

Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

Dark pools allow investors to buy and sell large quantities of stock away from the scrutiny of public exchanges. We will follow an institutional investor as he makes a dark pool trade and explore the regulatory environment dark pools operate in.

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.

Dark Pool

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.

Dark pools may have trading rooms like this one
Trading room

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.

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