What is a Dark Pool?
A dark pool is trading activity that occurs directly between parties without the use of an exchange, thereby keeping the transactions private.
How Does a Dark Pool Work?
Institutions usually create dark pools. Let’s assume Company XYZ and Company ABC are pension funds in California and Oregon, respectively. Company XYZ wants to sell 2 million shares of McDonald’s (NYSE: MCD) to Company ABC. However, the trade is so large that investors might regard the transaction as a sell signal on MCD, which could tank the stock and make further sales more difficult for the seller. Thus, the two companies decide to do the trade off the exchange (i.e., in a 'dark pool'). The transaction costs might also be lower.
Why Does a Dark Pool Matter?
Dark pools provide anonymity. They also provide a way to avoid destabilizing the markets if a trade is particularly large, and they increase liquidity in the markets by increasing the ease with which buyers can buy and sellers can sell. However, dark pools are controversial because they prevent all investors and market participants from knowing the true prices at which specific securities are valued in all arm’s-length transactions. Given that dark pool trading reportedly constitutes 20% of all market volume, according to some sources, the controversy is bound to continue or increase with its popularity.