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Navigating the Shadows: Exploring the World of Dark Pool Trading

While dark pool trading might sound mysterious and enigmatic, it's actually less complex than you might think.

Overall, dark pool trading has been garnering noticeable interest, particularly within the realm of cryptocurrencies, as a distinct method for executing trades away from the scrutiny of public exchanges such as Binance, KuCoin, or Kraken.

However, it's not a concept that originated from the crypto world. Thus, we'll have to look into what a dark pool trading system is in order to understand how it works in the crypto world. So, grab your virtual flashlight and explore the shadows of the dark pool trading system with me.

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What is Dark Pool Trading?

Dark pool trading is a concept that has been around for quite some time now and has originated in the stock world. But what is a dark pool in trading, exactly?

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Well, imagine a private pool at a party to which only certain people are invited, but instead of water, it's filled with trades. That's the basic idea behind a dark pool.

If we were talking in more formal terms, however, a dark pool is an alternative trading system (ATS)[1], an exclusive trading venue where large institutional investors, like hedge funds or big banks, can buy and sell large amounts of assets without revealing their intentions to the public.

Why the name "dark pool", though? It sounds a bit sketchy. Well, it's because these trades happen away from the public eye, in the shadows, so to speak.

Dark pool trading systems were initially created to provide a discreet environment where institutional players could execute their trades without causing significant market disruptions or revealing their strategies to other traders.

Dark pool trading: stock charts.

The way a dark pool works is quite intriguing. Instead of executing trades on public exchanges, like the stock or the crypto market, dark pools match buy and sell orders internally. They act as a sort of middleman, bringing together buyers and sellers without broadcasting the details of the trades to the outside world.

Now, as I mentioned before, this type of trading is becoming more and more popular in the crypto world. But does dark pool crypto trading differ much from traditional dark pool trading?

Put shortly, not really. The dark pool trading crypto concept offers an environment for large-scale buyers and sellers to execute trades away from public exchanges. The aim is the same – to minimize price impact and maintain privacy, albeit in the context of digital assets.

Origins of Dark Pool Trading

Now that you know what is a dark pool in trading (both crypto and traditional), you might be curious about where this unique concept came from. To truly understand the origin of dark pools, we must first journey back to the early 1980s[2]. It was during this time that a revolution in trading began to take shape.

In the 80s, traditional stock exchanges (like the New York Stock Exchange) were the go-to platforms for buying and selling stocks. However, as technology advanced and trading volumes soared, these exchanges faced challenges in handling the increasing order flow.

In response, institutional investors and large brokerage firms sought alternative ways to execute their trades. They wanted a system that could provide better liquidity, minimize price impact, and maintain a level of confidentiality. This desire gave birth to the concept of dark pools.

The term "dark pool" itself conjures up images of secret gatherings and hidden agendas. In reality, though, they're not as ominous as they sound.

Dark pool trading: private meeting.

Put simply, dark pools operate on the principle of "hidden liquidity." This means that buy and sell orders are matched internally within the dark pool without being visible to the broader market. The details of these trades are disclosed only after the transactions have been completed, providing an extra layer of privacy for participants.

Thus, the name simply refers to the lack of transparency surrounding the trading activity that takes place within them.

The first dark pool was established by an institutional investor looking for a more discreet trading venue. Besides, initially, these alternative trading systems operated independently from traditional exchanges. However, as their popularity grew, some exchanges decided to launch their own dark pools to retain market share.

Types of Dark Pools

Now that you have the basic knowledge of what is dark pool trading system, you should also know that there are several types of pools that exist. Each one has its own unique characteristics and operates under different ownership structures.

Broker-Dealer-Owned Dark Pools

Broker-dealer-owned dark pools are operated by large financial institutions such as investment banks or brokerage firms. These institutions create their own private trading platforms, where their clients can execute trades away from public exchanges.

Agency Broker- or Exchange-Owned Dark Pools

In this type of dark pool, the ownership lies with agency brokers or exchanges.

Agency brokers act as intermediaries between buyers and sellers, executing trades on behalf of their clients. They operate their own dark pools to provide an additional avenue for executing trades away from the public markets.

Dark pool trading: people making a deal.

Exchange-owned dark pools, on the other hand, are operated by stock exchanges themselves. These exchanges create separate trading venues within their infrastructure to facilitate anonymous trading.

Agency broker- or exchange-owned dark pools often provide increased liquidity as they can tap into their existing client base.

Electronic Market Makers

Electronic market makers are a type of dark pool that is slightly different from the previous two types. Instead of acting as intermediaries, electronic market makers use algorithms to provide liquidity to the market. They continuously offer to buy and sell securities, profiting from the spread between the bid and ask prices.

Electronic market maker dark pools are known for their high-speed trading and ability to handle large trading volumes. They can also provide tighter spreads compared to traditional exchanges.

Crypto Dark Pools

As dark pool crypto trading is not the same as traditional crypto trading, it also has its own dark pools. To be more specific, there are two main types – centralized and decentralized pools.

Dark pool trading: cryptocurrencies.

Centralized dark pools operate as an extra feature on prominent crypto exchanges, aiming to provide a secure and private environment for executing cryptocurrency trades. You can simply change your order destination from a public order book to a dark pool.

Decentralized dark pools, on the other hand, function as separate platforms that focus specifically on dark pool trading. They work kind of like decentralized crypto exchanges do, apart from the fact that their focus is on large-scale traders.

Other Types of Dark Pools

Apart from the aforementioned types, there are other variations of dark pools that exist in the financial landscape. Some dark pools specialize in specific asset classes, such as bonds or derivatives. These specialized dark pools cater to traders who focus on these particular instruments.

Dark Pool Index and Dark Pool Indicators

To fully grasp what is dark pool trading system, you should also understand two important concepts – Dark Pool Index (DIX) and Dark Pool Indicators (DIP). These instruments offer valuable insights into the hidden realm of dark pool trading, providing investors with a unique perspective on market sentiment and trends.

Dark Pool Index (DIX) takes its cues from the renowned Standard & Poor's 500 index. However, it deviates from the norm by utilizing data from dark pools rather than public stocks associated with these companies.

The purpose of the DIX is to gauge whether the prevailing sentiment within dark pools leans towards bullishness (indicating an inclination to buy assets) or bearishness (signifying a predisposition to sell them). DIX is represented as a percentage ranging from 0 to 100%. The higher the percentage, the stronger the bullish sentiment is.

So, essentially, DIX serves as a measure of market sentiment within the shadowy depths. Just like the Fear and Greed Index does when it comes to the crypto market.

Dark pool trading: bull and bear.

Dark Pool Indicators (DIP) operate differently. While the DIX relies on the S&P 500, DIP focus on individual stocks' performance within the dark pool market.

It's worth noting, though, that DIX is a specific type of DIP that reflects how a basket of assets behaves within dark pools. DIP, on the other hand, can be used to measure different assets across the board.

If you're utilizing a specific program, you might even have access to the moving averages of various tickers. This enables you to observe long-term trends in the market, providing valuable insights for more informed decision-making.

These indicators serve not only as a means to invest in the dark pool but also as complementary tools for gaining deeper insights into mainstream markets such as the NASDAQ or the New York Stock Exchange.

By leveraging the power of DIX and DIP, investors can navigate the shadows with a clearer understanding of market sentiment and trends, as these tools offer a glimpse into the otherwise concealed world of dark pool trading.

Pros and Cons of Dark Pool Trading

Dark pool trading brings quite a lot of benefits, such as reduced slippage and increased anonymity. However, it also brings various drawbacks, including concerns about transparency and potential manipulation. So, let's look into that in more depth.

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Pros of Dark Pool Trading

It's always best to start on a positive note. Therefore, I'll go over the pros of dark pool trading first.

✓ Enhanced Privacy and Reduced Market Impact

One of the main advantages this type of trading has is the enhanced privacy it offers to traders. In traditional exchanges, when large orders are executed, they can significantly impact the market, causing prices to fluctuate.

However, in dark pools, these large orders can be executed without revealing the full details to the public, reducing the market impact. This privacy can be particularly beneficial for institutional investors or individuals who want to keep their trading strategies confidential.

✓ Reduced Transaction Costs

Another significant advantage of dark pool trading is the potential for reduced transaction costs. In traditional exchanges, the bid-ask spread, which is the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept, can be wide.

Dark pool trading: sell or buy.

Dark pools allow for more efficient matching of buy and sell orders, potentially narrowing the bid-ask spread and reducing transaction costs for participants. This can be especially valuable for large institutional investors who regularly engage in high-volume trades.

✓ Improved Liquidity for Large Orders

Dark pools can provide a favorable environment for executing large orders. In traditional exchanges, placing a substantial buy or sell order can attract attention and lead to unfavorable price movements due to market impact.

However, in dark pools, the order information is hidden, which can prevent adverse price movements. As a result, institutional investors or traders with significant positions can find it easier to execute large orders without causing disruptions in the market.

✓ Access to Diverse Participants

Dark pools often attract a diverse range of market participants, including institutional investors, hedge funds, and high-frequency trading firms.

This diversity can create a more dynamic trading environment, offering participants the opportunity to interact with a wider pool of potential counterparties. The presence of different participants can also increase the depth and liquidity of the market, making it easier to execute trades.

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Cons of Dark Pool Trading

With its mysterious allure and hidden nature, dark pool trading may seem like an attractive option for investors seeking privacy and anonymity. However, like any other trading system, it comes with its fair share of drawbacks, too.

✗ Lack of Transparency

One of the major downsides of dark pool trading is the lack of transparency. As I mentioned several times already, unlike traditional exchanges, dark pools operate away from the prying eyes of the public. While this provides anonymity, it also means that participants have limited insight into the market.

The absence of real-time information about buy and sell orders can make it difficult to gauge the true market demand and price of a particular asset. As a result, investors may miss out on valuable insights and opportunities for informed decision-making.

✗ Limited Price Discovery

The reduced visibility of dark pool trading can also hinder the process of price discovery. Price discovery refers to the mechanism by which the market determines the fair value of an asset based on the forces of supply and demand. With dark pool trades being hidden from the public eye, the information needed for accurate price discovery is restricted.

Dark pool trading: a man calculating money.

This lack of price transparency can lead to potential discrepancies between the dark pool prices and the prices on the open market, which may impact the overall market efficiency.

✗ Potential for Market Manipulation

The veiled nature of dark pool trading opens the door to potential market manipulation.

Since trades within dark pools are not immediately reported to the public, certain participants (including dark pool operators) can take advantage of this opacity to manipulate prices or execute large trades without alerting the broader market.

Such practices have the potential to create an unjust advantage for individuals who have access to dark pools, leading to a distortion of the actual market conditions. Consequently, this puts other investors at a disadvantage, particularly those who rely on publicly available information.

✗ Regulatory Concerns

Dark pool trading has attracted regulatory scrutiny due to its potential risks. Regulators are concerned about the lack of transparency, which can hinder their ability to monitor and ensure fair trading practices.

Besides, the potential for market manipulation and its impact on price discovery raises concerns about the integrity of the overall market. As a result, regulatory bodies may impose stricter regulations on dark pools to safeguard the interests of investors and maintain market integrity.

All in all, keep in mind that while the privacy and anonymity aspects of dark pool trading may be appealing, the potential risks of engaging in it should not be overlooked.

What About Dark Pool Regulations?

Now, have you ever wondered how dark pool trading, with its air of mystery and borderline suspicious reputation, is actually regulated (and whether it is regulated, in the first place)?

Well, dark pools are indeed subject to regulations. However, they vary across different jurisdictions. The primary objective of these regulations is to strike a balance between facilitating market efficiency, as well as promoting fairness and transparency.

Countries acknowledge the need to regulate dark pools to protect market integrity and investor interests while also recognizing the benefits they can offer in terms of liquidity and price improvement.

For instance, regulators may mandate dark pools to disclose the percentage of trades executed at the midpoint of the national best bid and offer. This disclosure provides valuable insights into the liquidity and competitiveness of the market, allowing participants to gauge the efficiency of the dark pool venue.

Dark pool trading: regulations.

Regulators also focus on preventing any form of market manipulation or abuse within dark pools. They implement measures to deter fraudulent activities and protect investors.

Furthermore, some jurisdictions may impose restrictions on the types of participants allowed to access dark pools. This is done to maintain a level playing field and prevent unfair advantages that could undermine market integrity.

Regulators may also require participants to meet specific criteria, such as minimum trading volumes or capital requirements, to ensure that only qualified market participants engage in dark pool trading.

On top of that, it's worth noting that dark pools in the US are subject to stringent regulatory requirements similar to those imposed on traditional stock exchanges. This includes the necessity to register with the Securities and Exchange Commission (SEC) and provide specific information about their operations.

To sum up, dark pool regulations vary across jurisdictions, with a common focus on promoting fairness, transparency, and market integrity. Disclosure requirements and measures to prevent market manipulation also play a crucial role in maintaining a level playing field.

Examples of Dark Pools

I'm sure that by now, you already know an answer to the question, "What is dark pool trading system?", but I bet you also want to know some real-life examples of dark pools (both in the traditional and the crypto trading worlds).

Liquidnet

Liquidnet is a widely recognized dark pool platform. It was founded in 2001 and has become a standard destination for institutional investors seeking to execute large block trades with minimal market impact. The platform claims to have global reach, connecting traders from different parts of the world.

One of the key features of Liquidnet is its focus on protecting client anonymity. The platform operates as an independent broker-dealer, meaning it does not engage in proprietary trading or market-making. This seeks to ensure that clients' orders remain confidential and are not exposed to the broader market, reducing the risk of price slippage.

IEX

Made famous by the book "Flash Boys" by Michael Lewis, IEX is another noteworthy dark pool platform. IEX, which stands for Investors Exchange, was launched in 2013 with the aim of addressing concerns regarding high-frequency trading and market manipulation. IEX gained attention for its innovative approach to leveling the playing field for investors.

The platform uses a unique trading mechanism known as a "speed bump," which introduces a slight delay in order execution. This delay helps to neutralize the advantage of high-frequency traders, providing a fairer trading environment for all participants.

Dark pool trading: IEX.

sFOX

sFOX is one of the few players in the dark pool trading crypto space. As digital assets gained prominence, the need for secure and efficient trading platforms became evident. sFOX aims to address this need by offering a dark pool specifically designed for cryptocurrencies.

By leveraging advanced technology and liquidity aggregation, sFOX seeks to provide traders with access to deep pools of liquidity while minimizing the impact on the broader market. The platform emphasizes security and compliance, catering to institutional investors and high-net-worth individuals looking to execute large cryptocurrency trades.

Kraken Dark Pool

As the name suggests, the Kraken dark pool is a pool that was launched by one of the prominent crypto exchanges – Kraken. It was introduced in 2015 with the intention of giving traders complete anonymity when placing large buy or sell orders. It was the first centralized dark pool for BTC (which also later started supporting ETH).

Dark pool trading: Kraken.

Overall, the dark pool only allowed making orders with BTC or ETH pairs with CAD, EUR, GBP, JPY, and USD (or with the ETH/BTC pair). When it comes to fees, Kraken charged from 0.20% to 0.36%, depending on the user's 30-day trading volume.

However, as of writing, it seems that the Kraken dark pool is not available anymore.

Republic Protocol (REN)

Republic Protocol (REN) was a decentralized dark pool that used atomic swaps to provide users with cross-chain crypto trading. It allowed the exchange of Ethereum, Bitcoin, and other ERC-20-based tokens. The protocol's native token, REN, was used to reward nodes that performed the order-matching process inside the protocol. These tokens were also used to pay network order fees.

Unfortunately, despite the fact that the project seemed promising, it was acquired by the infamous Alameda Research in 2022 and was pulled down together with it, eventually shutting down almost a year after the acquisition.

All in all, these examples highlight the diversity and innovation within the world of dark pool trading. However, it's important to note that they represent just a fraction of the existing dark pool landscape. Numerous other dark pools, both independent and operated by exchanges, cater to the needs of a variety of market participants.

Conclusions

Dark pool trading is an interesting concept that has gained significant traction. It offers a discreet way for institutional investors to execute large trades without impacting market prices. Even though it's a concept borne in the stock market, it has spread its roots into the crypto market as well.

Though, it's important to consider the implications of participating in dark pool trading, as it usually operates outside the realm of traditional trusted exchanges (like Binance, Kraken, or KuCoin) and may not suit all types of investors.

Nevertheless, whether you're a curious observer or an active participant, exploring the world of dark pool trading unveils a fascinating realm that plays a unique role in the ever-evolving financial ecosystem.


Scientific References

1. S. Buti, B. Rindi, I. M. Werner: 'Dark Pool Trading Strategies, Market Quality and Welfare';

2. H. Baǧci: 'Dark Pool Application in the Stock Exchange. Academic Research in Social, Human and Administrative Sciences-I'.

About Article's Experts & Analysts

By Ain N.

Lead Content Researcher

Ain is the Lead Content Researcher. Her vast experience with crypto and blockchain tech-related content allows her to identify the key pieces of information that should be presented to the learner, and ensure the validity of the gathered data. Wit...
Ain N., Lead Content Researcher
Ain is the Lead Content Researcher. Her vast experience with crypto and blockchain tech-related content allows her to identify the key pieces of information that should be presented to the learner, and ensure the validity of the gathered data.
With a degree in New Media studies, she has developed an extensive list of techniques to educate people via new, research-proven study models based on deduction and long-term human memory.
Ain approaches everything with unequivocal attention to detail. Her main goals are to erase the ambiguity surrounding many Web3 concepts, and to guide content writers in presenting difficult crypto-related concepts in an easy-to-understand manner.
Even though content strategy is her main passion, Ain also enjoys reading high-fantasy books and watching superhero movies.

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FAQ

What is a dark pool in trading?

A dark pool in trading refers to a private platform where large institutional investors can buy or sell significant amounts of financial assets, like stocks or cryptocurrencies, without disclosing their intentions to the wider market. It operates outside the traditional exchanges like NYSE, NASDAQ, and BSE, or their crypto counterparts - Binance, KuCoin, and Coinbase. Though, some crypto exchanges tried integrating dark pool functionality into their platforms. For example, Kraken launched a dark pool in 2015 (however, as of writing, it's not available).

How does dark pool trading work in the crypto world?

In the crypto world, dark pool trading functions similarly to its traditional counterpart. It involves the private trading of digital assets, such as cryptocurrencies, away from public exchanges like Binance, Kraken, or KuCoin. Dark pool crypto trading provides a confidential environment for institutional investors and high-net-worth individuals to execute large trades without impacting the overall market. By minimizing market impact, dark pools help to avoid price fluctuations that could occur if these large trades were conducted openly on public exchanges.

How to pick the best crypto exchange for yourself?

Picking out the best crypto exchange for yourself, you should always focus on maintaining a balance between the essential features that all top crypto exchanges should have, and those that are important to you, personally. For example, all of the best exchanges should possess top-tier security features, but if you're looking to trade only the main cryptocurrencies, you probably don't really care too much about the variety of coins available on the exchange. It's all a case-by-case scenario!

Which cryptocurrency exchange is best for beginners?

Reading through various best crypto exchange reviews online, you're bound to notice that one of the things that most of these exchanges have in common is that they are very simple to use. While some are more straightforward and beginner-friendly than others, you shouldn't encounter any difficulties with either of the top-rated exchanges. That said, many users believe that KuCoin is one of the simpler exchanges on the current market.

What is the difference between a crypto exchange and a brokerage?

In layman's terms, a cryptocurrency exchange is a place where you meet and exchange cryptocurrencies with another person. The exchange platform (i.e. Binance) acts as a middleman - it connects you (your offer or request) with that other person (the seller or the buyer). With a brokerage, however, there is no “other person” - you come and exchange your crypto coins or fiat money with the platform in question, without the interference of any third party. When considering cryptocurrency exchange rankings, though, both of these types of businesses (exchanges and brokerages) are usually just thrown under the umbrella term - exchange. This is done for the sake of simplicity.

Are all the top cryptocurrency exchanges based in the United States?

No, definitely not! While some of the top cryptocurrency exchanges are, indeed, based in the United States (i.e. KuCoin or Kraken), there are other very well-known industry leaders that are located all over the world. For example, Binance is based in Tokyo, Japan, while Bittrex is located in Liechtenstein. While there are many reasons for why an exchange would prefer to be based in one location over another, most of them boil down to business intricacies, and usually have no effect on the user of the platform.

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