Dark pools are favorable for institutional investors executing block trades, perhaps when taking a significant position in an investment. Most retail investors buy and sell securities without ever influencing the price of the underlying security since there are so many outstanding securities on the secondary market.
However, an institutional investor possesses the buying power to purchase or sell enough securities to move the prices.
So, what exactly are dark pools in crypto?
What is a Dark Pool?
A dark pool is a private financial exchange organized for trading financial securities that are not accessible to the investing public.
Dark pools allow investors to trade without public exposure until after the trade is executed and cleared. When orders are placed in a dark pool, it helps stem massive price volatility that may result from a large order in the book of a public exchange. It is favorable for investors, such as hedge funds and activist investors, who do not want the public to know which positions they are taking.
How it Works
Exchanges are set up purely in a digital form. This move gives way to an increased number of dark pool exchanges that allow investors to trade securities on a secondary market with lower prices since they are not run by institutional banks or organized public exchanges.
When a large order, millions of dollars, is placed in the market, it can create panic.
For example, what would you do if you bought a cryptocurrency recently, hoping that the price would increase in a day or two, and then someone places a sell order for millions of dollars visible in the order book?
Your guts would tell you that the price may fall rapidly if the order is filled, but now you are on the wrong side of the market. The mentality would quickly force everyone to sell their crypto, which could also generate a selling frenzy. This is definitely what happens if someone overly places a large purchase order.
Uses of Dark Pools
Dark pools help fulfill the need for smaller exchanges to fulfill liquidity requirements. Several private financial exchanges are established, and it facilitates traders who receive substantial orders and cannot complete them on traditional public exchanges. Dark pools add to the efficiency of the market since there is additional liquidity for particular securities by getting them to list on the exchanges.
Advantages of Dark Pools
Private trading
Dark pools allow for trading execution away from the face of public markets. Public markets tend to overreact or underreact due to news coverage and market sentiment. The pools facilitate trades that will trigger price overreaction or underreaction.
Avoidance of price devaluation
With dark pools, large trades can be broken into smaller trades and executed before the security price becomes devalued, where the price will have certainly decreased by the time the order is filled.
The disadvantage of Dark Pools
Lack of transparency
Since dark pools operate with little oversight, they are heavily scrutinized for not putting as much regulation as other public exchanges.
Takeaway
Dark pools have coexisted with regular trading platforms, and they continue to serve a large community of traders who think they can benefit from such pools.
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