Dark pools of liquidity are basically stock exchanges that are private and designed mainly for trading the large blocks of securities. Platforms like FinCrowd App can help an investor to get started with a dark pool. But due to its complete lack of transparency, it is termed as “dark”. This can be very beneficial for the big players but the retail investor can face a huge loss.
Disadvantages of Dark Pools
Dark pools do have some drawbacks due to which one must refrain from using it. Some of these disadvantages are mentioned below:
- It is not necessary that the exchange prices will reflect the real market. There are chances for exchanges to not reflect the actual market if the number of trading in dark pools that are owned by electronic market makers, brokers or dealers continues to grow. This can be very disadvantageous for a retail investor.
- For instance, if a mutual fund that owns 30 percent of a company’s stock but sells it in a dark pool, the fund may fetch a good price for it but the investor who just bought these shares might have ended up paying too much for it.
- It is not assured that a pool participant will get the best price. Because of lack of transparency in dark pools, there is no surety that execution of the institution’s trade was at the best price which can actually work against a pool participant. Also, due to its opaque nature, there can be conflicts of interest in the case of a trade by broker-dealers proprietary traders against the pool clients.
- It makes you vulnerable to predatory trading. Some firms find a dark pool client orders as a perfect fodder for practicing predatory trading. Pinging is one of such practices. To detect large hidden orders in dark pools, a high-frequency trading firm places small orders. Once they are able to detect such an order, the firm will front run it and make profits at the expenses of the pool participants.
- Say for example, when bids and offers are placed in small lots by a high-frequency trading firm for a large number of listed stocks, if the order for stock ABC executes, then this will alert the high-frequency trading firm regarding the presence of a large order for the stock ABC. Later the high-frequency trading firm would buy all the shares of ABC available in the market and sell them back to the same institution which is already a buyer of these shares.