Does Trading In 'Dark Pools' Hurt Small Individual Investors?

Investors who blame financial firms for big losses during the 2007-09 recession could be forgiven for raising an eyebrow at "dark pools" of investment funds.

Should IBD-style investors worry about the pools now

Funds trading large blocks of shares may benefit from small price discrepancies found in dark pools. However, trading on the private exchanges has little impact on individual investors.

That's because volume on the Nasdaq, NYSE and other major exchanges remains a reliable indicator when it comes to buying and selling stocks.

IBD tracks volume on the Nasdaq, the Dow Jones industrial average and the S&P 500 (see Page B8) each day. Study these charts and read the Big Picture (today on B9) each day to discern whether the market is under accumulation (buying in higher volume) or distribution (heavy selling).

What Are Dark Pools?

Dark pools allow big funds to trade blocks of shares in private — off the major exchanges — as a way to hide their activities from rivals and the public. They have grown in popularity over the past decade. News reports and academics estimate that volume on private exchanges ranges from roughly 12% to 40% of total U.S. trades.

Mutual funds and other big investors are attracted to these exchanges because they can buy shares without moving a stock's price on the major exchanges. This helps them keep costs low, since they typically buy into a stock in stages rather than all at once.

For example, if word gets out that a large fund plans to buy a block of Alcoa (AA) shares, other investors may jump in beforehand and cause the price to spike, causing the fund to buy at a higher price.

Critics warn that dark pools hinder "price discovery" — the process by which trading on a public exchange yields the best price for a given stock — and further erode investors' trust in the market.

In particular, they say high-frequency traders could game the system by using computer algorithms to profit from price differences between the exchanges and the dark pools.

Major exchanges such as the Nasdaq and NYSE Euronext have also argued that fragmentation of the market into a greater number of exchanges could result in thin trading volumes in each platform, leading to greater volatility. About 45 dark pools compete with 13 public exchanges in the U.S., Reuters reported in April.

In a bid to retain investor trust in the markets, the Financial Industry Regulatory Authority in June began publishing weekly data on the total shares traded by security in each dark pool.

Others downplay concerns about dark pools.

MIT economist Haoxiang Zhu, conducting a study based on a model of investor behavior, says it may be hard for institutional investors to execute trades in dark pools if many of the parties in the pool have equally detailed knowledge about a stock.

"Many of those smart investors will discover liquidity problems in the dark pool: They crowd on one side of the market, and there may not be enough underinformed investors willing to take the other side of the trade," Zhu wrote in "The Review of Financial Studies." Those well-informed investors would have to migrate back to the public exchanges to fully execute their trades, he added.