If you are a fan of the Lord of the Rings, the phrase "dark pool" might conjure up visions of Gollum hunting for his dinner in a dank cave. For investor relations professionals, dark pools are another set of rapids in the churning financial arena.
The "dark" in dark pools refers to liquidity in your stock that is not transparent to the markets. With transparent or "light" liquidity, market participants can see all requests to buy or sell a stock, along with the bid/ask price and the number of shares.
An example of "light" liquidity can be seen in the Level II screenshot below.
Traders and algorithms use "light" liquidity information to judge supply and demand, when they attempt to gauge price movement. If there is more selling supply than buying demand, the price would be expected to drop. Conversely, if there is more buying demand than selling supply, the price would be expected to rise.
The difference between the bid price and the ask price is called the spread. The spread is the cost a market maker charges for being the intermediary between the buyer and seller and is an indication of the risk the market maker is willing to assume.
One event that almost always causes the spread to widen is when a large block of liquidity appears on either the bid or ask side. When a buyside firm places an order to buy 100,000 shares of a stock that usually trades in average orders of 100-300 shares, it is more than likely that the price will rise to meet the demand. The buyside order will be filled in pieces, as the spread widens and the price moves higher. Even worse, if word of the buyside firm's interest "leaks" to other participants, more and more buyers will appear, attempting to "front run" the buyside order and ride the almost guaranteed rise in price for a quick profit.
Needless to say, the above scenario results in the buyside firm paying much more to acquire a large quantity of shares (or losing much more when trying to sell). In order to counteract the impact of large block trades on the price received, the buyside has actively sought an arena where their actions are opaque or dark.
Dark liquidity, as the name implies, is not transparent to the market. Pools of dark liquidity have been around for a long time. A specialist on the NYSE floor with a 100,000 share buy order could be considered a source of dark liquidity. They may walk around the floor, looking to match their buyer with a seller. However, every trader they speak with causes another leak of information and potential for front running.
So, what has caused dark pool volume to skyrocket, in less than ten years, from almost nothing to nearly 10% of all shares traded?i Like most powerful trends, the rise in dark liquidity volume has been a confluence of events. First, decimalization reduced the spread between the ask and the bid price, pressuring this source of revenue for sell-side firms. Second, the rise of electronic communication networks (ECNs) introduced new methods for accessing liquidity. And third, the use of algorithms allows for a level of complexity and access to liquidity unimaginable just a few years ago.
Now, when the buyside looks to buy or sell a large block of shares, they can hide their intent by utilizing dark pools of liquidity. Sellside firms have opened up their internal liquidity along with facilitating other requests for liquidity. Algorithms allow for the rapid search for this anonymous liquidity across multiple sellside books. Each firm has different rules for how it handles dark liquidity requestsii. Some pools are darker than others. Rules and levels of darkness can be programmed into the algorithms and tailored to the buyside requirements.
Unlike our light liquidity example, no dark liquidity shows up on any screen until after the transaction is complete. Sellside firms make their money by charging several cents per share traded, rather than relying on the bid/ask spread. However, since the transaction is dark, it can be very difficult for the buyside to confirm they received the best price.
What does all of this mean for investor relations professionals? For one thing, if you hope to identify dark pool activity through traditional stock surveillance, forget it. The entire reason for dark pool liquidity is that the transactions are anonymous and opaque to the market. The buyside has little interest in making you or anyone else aware of their activity.
Before you can understand what impact dark pool activity may be having on your stock's market structure, you need to identify where the liquidity is being traded. The only way to do this is to identify the desks on your exchange that handle this liquidity. Dark pool activity on its own is not bad or good. However, large swings in volume and deviation from the average can help you identify changes in your stock's market structure that you can act upon.
To find out how ModernIR's Equity Analysis™ can give you more insight into dark pool and other trading activity along with actionable IR information, please contact us.
Margaret E. Wyrwas - Knight Capital Group, Inc. (Nasdaq: NITE)
Senior Managing Director, Corporate Communications & Investor Relations
Equity Analysis™ subscriber since March 2007
"In global markets driven by automation, changing market structure regulation and dynamic investment objectives, today's investor relations professionals require new data points in order to remain relevant and add value in their company's quest to reduce its cost of capital."
