Prior to the creation of dark pools, funds utilized two methods to execute large orders in order to minimize market impact and information leakage. The first method was to split up larger orders into multiple smaller orders which are then executed on the public exchange. The second method was to utilize a broker specializing in block trading who would then look for a counterparty willing to fulfill that offer (12). Despite measures to prevent market impact and information leakage, traders managed to take advantage of these methods by capturing information from the split trades and information leaked by brokers.
Dark pools operate without pre-trade transparency, which means that prices and the parties pertaining to the trade are not reported until the transaction has been completed (1), differentiating itself from public exchanges which are highly transparent. Through this process, dark pool are able to offer significant benefits to its participants through reducing market impact and reducing information leakage to the market place (13). A result of this is of course price improvement. As buy-side institutions no longer have to slicing their trades into multiple smaller positions on the public exchange, they are able to avoid paying multiple transaction fees and only need to pay a single fee by processing their whole trade through a dark pool (10). In addition, avoiding sliced trades allows participants to complete their trades much quicker, thus reducing their market exposure and reduce the possibility of incurring costs arising from price volatility (10).
Furthermore, the anonymity granted by dark pools allows institutions reduce information leakage which could cause high frequency traders to take advantage of their positions. As a result, this reduces the potential market impact of their trades as prices are less likely to move against them (3). Further price improvements are possible through broker-dealer operated dark pools as they have a large pool of clients and are able to internally match transactions without the need to engage with an external dark pool operator, thus eliminating the need to pay multiple transaction fees (2). The avoidance of public exchanges also means that clients do not have to pay exchange fees (3). Savings on fees are split between the operator and the client creating price improvement for the client while at the same time improving revenue for the operator, providing mutual benefits to both the buy-side and sell-side players (2).
In addition to the price improvement benefits, dark pools have also been touted to improve the level of service in the market by introducing competition to traditional exchanges (10). This can be interpreted as a good sign by the government and regulators as increased competition translates into more benefits for the consumers and a more dynamic marketplace. An implication of this is that dark pools have forced stock...