Dark Pool Liquidity

Liquidity defines the extent to which an asset could be expeditiously purchased or sold in the market without impacting the asset’s price.

Market liquidity denotes magnitude to which a market (a nation’s share market, property market) enables an asset to be purchased and sold at steady rates.

The most liquid asset is cash. Cash is actually the benchmark for liquidity since it can expeditiously be transformed into another type of asset.

Accounting liquidity is the assessment of an individual’s capability to repay the debts whenever they become due, specifically, to be able to access their cash whenever it is required.

Liquidity refers to the trade-off between the quickness of sale and the rate at which it is sold. In a market, which is liquid, the trade-off is not severe; selling expeditiously would not decrease the rate significantly. However, in an illiquid market, selling expeditiously would need a substantial price reduction.

The process of trading an asset, which is not very liquid for a more liquid asset is known as liquidation.

Liquidity is interpreted properly in several accounting systems and has been well-defined in recent times. For e.g., the US Federal Reserve aims to leverage quantitative liquidity needs on the basis of Basel III liquidity procedures.

The stakeholders in a bank would have to validate key liquidity risks directly.

The market liquidity of assets impacts their rates and estimated returns. Practical data indicate that investors need a greater return on assets with lesser market liquidity to compensate them for a greater expenditure of trading the assets.

In other words, for an asset with a specified cash flow, greater its market liquidity, greater its price and lesser is the estimated return.

Again, investors who are risk-averse need significant estimated return if the asset’s market liquidity risk is higher.

From a financial perspective, a dark pool (also called black pool) is an independent medium for dealing in securities. Liquidity in such markets is known as the dark pool liquidity.

The majority of dark pool trades reflect mega deals by financial organizations that are provided away from stock exchanges such as the New York Stock Exchange and the NASDAQ. This ensures all trades are confidential and external to the purview of the retail investor.

The breakup of financial trading locations and electrical trading has enabled dark pools to be formed, and they can be accessed via crossing networks or precisely between market players through secluded legitimate measures.

Certain dark pools can be accessed by the retail investor through a broker.

A critical advantage for institutional investors in utilizing dark pools is for purchasing and selling huge quantities of securities without revealing their identity to others, thereby evading market influence since neither magnitude of the trade nor distinctiveness are affirmed until the trade is completed.

However, it also denotes that certain market players lose out since they cannot view the trades before they are implemented; rates are finalized by participants in dark pools. Hence, the market loses its transparency.

The three key types of dark pools are:

·         Private firms established to provide a distinctive differentiated basis for trading.

·         Dark pools managed by brokers wherein clients of the broker communicate among themselves under the circumstances of secrecy.

·         Certain public exchanges establish internal dark pools to provide their clients the benefit of secrecy.

Depending on the specific method in which a “dark” pool functions and collaborates with other locations, it could be treated, and definitely denoted by some dealers, as a “gray” pool.

The systems and plans normally seek liquidity amid open and closed trading locations like other trading systems.

Dark pools have become prominent since 2007. They are of different categories and can implement the trades in various ways (negotiation or automatically), during the day or at specified periods.

Some key facts about dark pools:

·         It used to be called as “upstairs trading” previously.

·         Institutions can execute the orders without revealing the complete order to ensure investor confidence in the long-term.

·         They are governed by stringent regulations.

·         Investors “opt-in” to place orders in a dark pool to leverage benefits of not revealing the order details at an exchange.

Dark pool trades are regulated by National Best Bid and Offer “NBBO”.  The volume of trading is high in dark pools since institutions prefer them.

Various dark pools have different aspects to appeal to several sections of the market. Often a seller and a buyer are not available at the same time to confirm a sale.

Buy-side investors looking for liquidity without being visible to prominent traders and market stakeholders are seeking shelter in one of the dark pools.

According to Michael Cashel, Senior Vice President at Fidelity Trading Ventures, “They hate the fact that the other side of the trade walked away and took information from them.”

Dark pools assist in reducing market influence. There is a probability of price enhancement and decreased transactional charges.

Technological advancements have enabled algorithmic trading, thereby increasing the market speed. In such a scenario, dark pools are preferred by institutional investors due to the capability to implement mega orders across lesser trades while reducing market influence.

Dark pools have had an overall positive impact on markets. However, exchanges deliver a benefit to the investors by facilitating price detection. If a significant portion of the trading were to happen away from displayed locations, the quality of the market would decline in the long run.