What are dark pools and why does India avoid them?

Around 40 percent of the total traded volumes in the US for the year of 2019 took place in these dark pools.

A senior official of the National Stock Exchange (NSE) of India highlighted last week how India’s transparent trading regulations left no room for something like “dark pools” that are common in the developed markets.

While Indian retail investors benefit from the regulation and transparency heralded by the exchanges and the regulator, large institutional investors in other markets can have an edge over smaller investors because of these dark pools.

What is a dark pool?

The ominous-sounding name refers to a private exchange that facilitates large trades without disclosing details to the public. Such deals can take place via black pools in certain European Union countries and the US.

In India, large trades are transacted through the bulk or block deal windows of stock exchanges. The buyers and sellers of large quantities of shares are usually big institutional investors or high net worth individuals.

When the trade is placed, information regarding the buyer, seller, price and quantity of shares that changed hands is disseminated and made public.

Who owns these dark pools?

Dark pools are typically owned and operated by brokerage firms. They serve as alternative trading venues for seeking to execute large orders with reduced market impact and increased confidentiality.

How does a dark pool work?

Imagine a large institutional investor such as a pension fund that wants to sell a significant number of shares of a company's stock. If it were to place such a large sell order on a public exchange, it could immediately impact the market price, potentially resulting in a lower selling price.

Instead, the pension fund decides to submit the sell order to a dark pool, specifying the quantity and any other relevant parameters. The dark pool's matching engine identifies a buy order that matches the sell order submitted by the pension fund.

Without disclosing the identity of the parties involved, the dark pool executes the trade internally, transferring the shares from the seller to the buyer at the agreed price.

What is the purpose of black pools?

A black pool often allows large trades to occur with complete anonymity, giving institutional investors the discretion to trade without heightened scrutiny.

When a large trade occurs in India, the stock price of the counter reacts sharply. An investor wanting to sell 1 million shares of a company might have to execute multiple trades. This would weigh on the stock since market participants would be aware there is a large seller offloading a sizable portion of its holdings.

However, when a large trade occurs in a dark pool, the information is not available to investors, and it mitigates any sharp upward or downward price movement. Buyers and sellers can complete their transactions without triggering a massive change in the stock price. It also allows them to trade at a price point that retail investors cannot access.

According to reports, about 40 percent of the traded volumes in the US in 2019 took place in dark pools.

Is it regulated?

The US Securities and Exchange Commission is attempting to regulate dark pools to make the transactions fair. In the European Union, dark pools are regulated under the Markets in Financial Instruments Directive framework. Once the trade is executed, it is reported to the public, but the identities are kept confidential.

Do dark pools work for retail investors?

The participants in dark pools are usually institutional investors with more experience, a larger corpus and more relevant information than retail investors. It can be profitable for investors that have easy access to levels of data and insights that retail investors rarely do. Additionally, since dark pools usually deal in heavy volumes, it might not make sense for a retail investor to use this mechanism.

Is it legal in India?

Dark pools are not legal in India. The domestic securities regulator focuses on providing a level playing field for all participants.

The Securities and Exchange Board of India has not demonstrated any shift in its stance in terms of allowing the mechanism to function since such trades occur outside the purview of the exchanges and the opacity and lack of regulation could create issues.

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