When the private room is cheaper

Vol #220: March 27th, 2025

Pull back the corded FIX connections, and you’ll find an exclusive network where trades happen before the market knows.

The guest list here is carefully curated, where some participants may be able to see who’s dealing, while others are operating completely blind. Flow is categorized by type, size, and toxicity to facilitate a seamless electronic match making service.

What happens in this space is agreed upon by the unique protocols of that room, but eventually must be exposed to the bright lights of market competition.

Behold, a dark pool.

The name implies something sinister, secret, and covetously exclusive; when you look behind the curtains, it's about as sexy as a night club with the lights turned on.

This dissonance leads to a lot of media attention. Bloomberg has written twice this quarter about a Darker Age and places that are Darker than a Dark Pool. With increasing quantities of shares traded here, and rules that begin to stretch the bounds of what is a competitive market, these venues do deserve some scrutiny.

Every asset class trades slightly differently, with differing mechanisms and participant types. In a completely decentralized world like crypto, it is pure degen vs. degen. At a pawn shop, you have one dealer trading against many customers. Bonds, equities, FX, and listed options all land somewhere in between.

Regardless of the underlying security, the purpose of markets is to clear transactions in a transparent and expeditious manner. Those prices tack towards valuation, driving price efficiency, and creating a robust and fair risk transfer. The role of brokers, liquidity providers, and buy side flow is to facilitate that.

Dark pools are born of the desire to trade more efficiently. One of the great ironies about the infusion of technology into trading is that faster feeds and machine readable everything creates a thinner and more jittery market at the surface.

Posted orders are a risk. Either as a dealer or a customer, leaving a bid or offer hanging out means you’re not updating as the market adjusts. Both sides want to transact, but each deserves a fair price. When every order represents a marginal piece of information, buyers want to be careful they’re not running price against themselves by showing their hand.

Lifting the offer on your bi-weekly 401k buy doesn’t really matter to the individual. The difference of pennies and dimes here means absolutely nothing to your long term returns. But when you’re an active market participant that is moving large blocks of stock for an institution, or hedging other activity, all of those pennies really add up.

Quality executions for large blocks of shares don’t come fast or cheap. While there might be ample liquidity at a price level, executing without slippage is a challenge. If offers are consistently taken, or there is a large displayed size on the bid, tape reading liquidity providers will fade their offers, uncertain whether this flow is price moving.

Dark pool trades in equities simply get printed on the tape. The price is reported by the broker dealer facilitating the transaction and has to be posted within sixty seconds. Many dark pools also take advantage of mid-point transactions, so neither side knows whether they crossed. Liquidity can silently post so you don’t know it’s there.

Structurally dark pools are regulated in a different way from exchanges, and so can implement different rules and segment flow in different ways. No two orders are alike, even if they have the same attributes. The toxicity of participants can be analyzed and managed so the pool can deliver a higher quality experience.

Flow that moves markets is considered to be toxic. If your orders are likely to be followed by a favorable market shift, no one wants to be on the other side. High frequency arbs and machine readable news flow is rarely desirable. On the other hand passive orders that are simply seeking liquidity are very attracative.

Within the club there’s even a VIP section - the “private rooms” of dark pools where another velvet cord separates those with shared values or investment goals. There’s an alpha argument that trading with people who are demonstrable long horizon would deliver a better execution price than where short termists might be trying to scalp you. I’ll buy it if the TCA (transaction cost analysis) says it’s true.

Overall this market fragmentation adds complexity, but dramatically reduces the implementation costs for large active traders. The cost drag of State Street rebalancing is passed through to every holder of $SPY. When options market makers can hedge more efficiently, they are going to be able to provide tighter spreads.

Dark pools in options don’t look exactly like they do with equities. You can seal the deal in the stock room. But for options there’s no trade reporting facility and everything has to cross on an exchange. With a few exceptions, that means any participant who’s paying attention has the opportunity to interrupt and price improve.

Yet these “dark pools” serve a similar purpose of reducing transaction costs for participants. As with equities, non toxic, passive, buy side orderflow is desirable engine of options market liquidity. Dealers compete to price this flow and thus improve the quality of markets.

A pre-exchange mechanism in options markets is the electronification of a process that has existed since calls were first listed. The negotiation process can take place on floor, over IM, or via electronic trading systems. With buyer and seller communicating either verbally or via the rules of engagement for electronic orders, they can arrive at a more fair price.

If an order is purchased and internalized by a single participant, it will still be subject to auction on an exchange. But if that order is purchased by an options dark pool, several participants will be able to come together and meet the size. They will also compete to set a higher starting price for the auction, further raising the bar for price improvement.

Not knowing who’s on the other side of an order is almost as good as knowing exactly who it is. Where dark pools in equities can screen out the bad flow for blind but non toxic interaction, in options they can exclusively focus on buy side flow from asset managers and retail brokers that’s under a certain size.

Lit markets still provide the benchmarks for these executions. Dark pool trades can’t be outside the bounds of the equity market, and every option order that’s auctioned must start at least on the bid/offer. If these erode too seriously, dark pools lose their effectiveness.

But any mechanism which is able to reduce transaction costs, encourage risk transfer, and tighten spreads is very good for markets. The dark room has nothing to hide.