'Dark Pools': Are Hidden Trades Undermining the Stock Market?

bell of the New York Stock Exchange
bell of the New York Stock Exchange

After the closing bell rings, whether it's the physical bell of the New York Stock Exchange or the virtual bell of the Nasdaq, you may believe that trading activity has ceased for the day and the shares of the companies you trade in are sitting quietly until the markets open again the following day. That's not necessarily true.

Behind the scenes, your companies may be seeing trading action in so-called "dark pools," secondary stock markets that operate out of sight of the average investor and beyond the reach of regulators.

The Yin and Yang of Trading

In financial jargon, "dark" is the opposite of "displayed." Displayed pools are regulated, public stock exchanges, examples of which include the NYSE and the Nasdaq. In a displayed pool, anyone who wants to buy or sell a particular equity has an equal view of all the activity going on with that company's available shares, including the volume being traded.

Dark pools are private exchanges that are used by institutional investors. In dark pools, brokers are typically trading large numbers of companies' shares, shares the average investor has no access to. Private operators of dark pools include Liquidnet and Pipeline, as well as broker-run operations like Credit Suisse's (CS) CrossFinder and Goldman Sachs' (GS) Sigma X.

Why trade in dark pools at all? If an institutional investor tried to move a large block of a company's shares on a traditional public exchange, that investor would likely find that the large volume moved the market, with a resulting price distortion. By trading in dark pools, institutional investors can trade at the enormous volumes they need to without automatically putting themselves at a disadvantage.

The People's Market

According to Financial Times, there are about 50 dark pools operating in the U.S. Counting the big broker-run operations, the newspaper estimates that nearly 40% of equity trading volume now occurs outside the traditional stock markets and in these dark pools. That's a lot of trading being done outside the view of the average investor.

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The stock market has its origins as a people's market, a way for middle-class citizens to get a share in the world's burgeoning commercial activity beyond what they did to earn a living. The Dutch East India Company was famous for being one of the first public companies to let anyone off the street buy a share.

But maybe more important, the stock market has been the primary capital creator for companies in the U.S. as well as the U.K. While German companies were more likely to turn to the banks for funding, and Japanese companies bought large blocks of stock in one another's companies to support growth, in America and Britain, companies rose on their ability to attract a larger volume of small investors.

Keep Investors Invested in the System

Dark pools are an invention of the marketplace, and serve a purpose. For big investors that need to move enormous numbers of shares around, dark pools offer a more level playing field. From the individual investor's perspective, one could argue that keeping these big trades off the public exchanges is also useful because of the price distortions they can inflict.

%Gallery-154016%And for any commodity, there have always been wholesale and retail markets. Buyers and sellers who can deal in large quantities have always had pricing advantages over the average end-of-the-line consumer.

But just as an income gap can get so wide that those at the bottom lose faith in the system and stop participating in it, or worse, start to work against it, the perception of an overly tilted playing field on the trading floor can cause the average investor to lose faith in the equities market. And that trust is something regulators should look to preserve. Millions of nest eggs and college funds depend on it, as well as all the companies and jobs that nest-building creates.

John Grgurich is a regular contributor to The Motley Fool, and owns no shares of any of the companies mentioned in this column. Motley Fool newsletter services have recommended buying shares of Goldman Sachs.

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